Haircut (finance)
Encyclopedia
In finance
, a haircut is a percentage that is subtracted from the market value
of an asset that is being used as collateral
. The size of the haircut reflects the perceived risk associated with holding the asset. However, the lender has a lien
for the entirety of the asset.
For example, United States Treasury bills, which are seen as fairly safe, might have a haircut of 1%, while for stock options, which are seen as highly risky, the haircut might be as high as 30%. In other words, a $1000 treasury bill will be accepted as collateral for a $990 loan, while a $1000 stock option might only allow a $700 loan.
Lower haircuts allow for more leverage
. Haircut has an important role on many kinds of trades, for example for Repo
or Reverse Repo.
applies a haircut to all securities offered as collateral. The size of the haircut depends on the riskiness and liquidity of the security offered as collateral.
Long Term Capital Management (LTCM) saw spectacular losses and required massive bail outs in 1998. Prior to that it was able to obtain practically next-to-zero haircuts as its trades were considered safe by its lenders. This was likely due to LTCM's clout and the fact that no counterparty
had a total picture of the extent of its complex and highly leveraged operations.
, options
, or futures
, haircut is used interchangeably with the term margin
. It is the amount of capital required by a broker to maintain the positions currently in a trading account. If haircut exceeds the account's capital, the broker can either require additional capital (e.g., margin call
), or liquidate positions until the haircut no longer exceeds available capital.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, a haircut is a percentage that is subtracted from the market value
Market value
Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...
of an asset that is being used as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. The size of the haircut reflects the perceived risk associated with holding the asset. However, the lender has a lien
Lien
In law, a lien is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation...
for the entirety of the asset.
For example, United States Treasury bills, which are seen as fairly safe, might have a haircut of 1%, while for stock options, which are seen as highly risky, the haircut might be as high as 30%. In other words, a $1000 treasury bill will be accepted as collateral for a $990 loan, while a $1000 stock option might only allow a $700 loan.
Lower haircuts allow for more leverage
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
. Haircut has an important role on many kinds of trades, for example for Repo
Repurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
or Reverse Repo.
ECB use of haircuts
The European Central BankEuropean Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...
applies a haircut to all securities offered as collateral. The size of the haircut depends on the riskiness and liquidity of the security offered as collateral.
LTCM and haircut fees
The speculative hedge fundHedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
Long Term Capital Management (LTCM) saw spectacular losses and required massive bail outs in 1998. Prior to that it was able to obtain practically next-to-zero haircuts as its trades were considered safe by its lenders. This was likely due to LTCM's clout and the fact that no counterparty
Counterparty
A counterparty is a legal and financial term. It means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context....
had a total picture of the extent of its complex and highly leveraged operations.
As used for exchange-traded products
When used in the context of exchange traded products such as stocksStocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
, options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, or futures
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
, haircut is used interchangeably with the term margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
. It is the amount of capital required by a broker to maintain the positions currently in a trading account. If haircut exceeds the account's capital, the broker can either require additional capital (e.g., margin call
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
), or liquidate positions until the haircut no longer exceeds available capital.