Secured loans require the borrower to put an asset with the lender, known as collateral, which the lender can sell in case the borrower doesn’t repay the loan. Determining the value of the collateral may be a tough task. But wouldn’t the value of the collateral asset be the same as its market value? No, and that’s where the term ‘haircut’ comes into the picture.
This article covers what a haircut in the share market is, features of a haircut, variables affecting a haircut, calculation and example of a haircut in the stock market.
What Is Haircut In The Stock Market?
The haircut is the percentage difference between the asset’s current market value and the value calculated for that asset when to be used as loan collateral. Since the market value of assets keeps fluctuating, the lender incorporates that fluctuation into the loan collateral value to reduce the risk of that asset falling in value.
Key Features Of The Haircut In The Stock Market
- The haircut value in the stock market is the amount deducted from the asset’s market value. The remainder is what the lender sees as a safe value before accepting the asset as loan collateral.
- The size of a haircut differs for different assets based on the level of risk involved in the asset class. The more the risk, the higher the haircut value and vice versa. Because of that reason, the haircut for equity may be higher than that for bond or debt security.
- The lender may increase or decrease haircut value based on changes in market conditions and the asset’s volatility. For instance, if the pledged stock shows high volatility, the lender may increase the haircut value.
Variables Affecting The Haircut Value
Creditworthiness of borrower
Whenever the lender gives a loan, he checks the borrower’s creditworthiness to determine whether the borrower would be able to pay back the amount. He might check his income, payment history, credit score, etc. The haircut percentage may be lower if the borrower is creditworthy, and vice versa.
Risks associated with the collateral asset
One of the primary factors used to determine the collateral value is the amount of risk associated with the asset class. The lender may consider the risk of not being able to sell the collateral asset at enough price if the borrower defaults.
Plus, the haircut value would be lower for collateral assets like T-bills, bonds, etc., since they involve lesser risk and have predictable prices. The haircut percentage may be greater in the case of assets with high risk and price uncertainty, like equity shares.
Liquidity of collateral
Liquidity means how easily and quickly the asset can convert into cash. If the collateral asset is highly liquid, meaning that the lender can sell it at a fair price and get cash quickly in case the borrower defaults, it would have a lesser haircut percentage. In contrast, if the collateral asset is less liquid, it would have a higher haircut percentage.
How To Calculate Haircut Value?
As stated above, the haircut is the amount remaining after subtracting the lender-recognised value of collateral from the collateral asset’s current market value. Here is the haircut calculation formula.
Haircut = Market value of a collateral asset – Value of collateral asset recognised by the lender
A haircut is usually stated as a percentage.
Haircut (%) = (Market value of a collateral asset – Value of collateral asset recognised by the lender) / Market Value of a collateral asset
Haircut Example In Stock Market
Here is an example of a haircut in the stock market.
For instance, Manan needs a loan of ₹6,00,000 and uses his equity portfolio worth ₹6,00,000 as collateral. In this case, the lender would not recognise the portfolio’s value as ₹6,00,000 due to price uncertainty risk. Suppose the bank recognises the portfolio’s value as ₹3,60,000. In that case, a reduction of ₹2,40,000 or 40% in the asset value is a haircut.
Final Thoughts
‘Haircut’ is simply the difference between a collateral asset’s market value and a value reasonable for that asset according to the lender based on the risk factor. It is meant to protect the lender. It is especially essential for repurchase agreement and reverse repurchase agreement trades.
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FAQs
Risk-based haircut means the percentage of reduction of the asset’s value used as collateral from the market value of that asset, based on the amount of risk involved. The more the risk, the higher the haircut and vice versa.
In the case of debt restructuring, a haircut means a reduction of unpaid interest payments or a portion of bond principal.
Haircut value means the externally determined lower-than-market value of the asset when the borrower uses it as collateral.
