Haircut (finance)


Haircut (finance)

In finance, a haircut is a percentage that is subtracted from the par value of the assets that are being used as collateral. The size of the haircut reflects the perceived risk associated with holding the assets.

For example, Treasury bills (which are seen as fairly safe) might have a haircut of 1%, while for a stock option (which are seen as less safe) the haircut might be as high as 30%. In other words, a $1,000 treasury bond will be accepted as collateral for a $990 loan, while a $1000 stock option might only allow a $700 loan.

When using loans to finance investment, the reciprocal of the haircut is the maximum possible leverage that can be achieved.

ECB use of haircuts

The European Central Bank (ECB) applies a haircut to all securities offered as collateral. The size of the haircut depends on the riskiness of the security offered as collateral. See the [http://www.ecb.int/pub/pdf/other/riskcontrolframeworken.pdf ECB Risk control framework]

LTCM and haircut fees

LTCM was able to obtain practically next-to-zero haircuts, as it wasconsidered 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 operations ref_harvard|Jorion99|Jorion (1999)|a

As used for exchange-traded products

When used in the context of exchange traded products such as stocks, 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.

Other uses

Haircut can also refer to the likely size of a loss.

References

* Jorion, P. (1999), "Risk Management Lessons from Long-Term Capital Management"


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