The Haircut is commonly used to differentiate the current market value of an asset and the value already placed on that asset in order to calculate regulatory capital or loan collateral. Haircut reflects after the asset value has fallen in cash sale or liquidation. Haircut can be seen also when calculating the percentage difference between an asset’s market value and the amount to be used as collateral for a loan.
Collateral Haircut is obtainable when the market value placed on an asset that is used as collateral for a loan is low. This is further expressed as a percentage of the markdown between two values. When the asset is used as collateral, the security is disvalued because a cushion is required by the lending party when the market value depreciates.
Furthermore, in cases where the collateral is pledged. The haircut is will be determined by the obtainable risk to the lender. The determinant risk could be the variables (such as price, volatility, liquidity, credit quality of the borrower) that affect. The value of the collateral in a scenario. Where the lender has to sell the security asset due to default by the borrower.
What you should know
- Do you know that Haircut collateral is the. Lower-than-market-value placed on an asset used as collateral?
- Do you know that the size of the haircut is. Dependent on the underlying risk of the asset? Thus, assets with higher risk call for larger haircuts.
- Do you know that haircuts can as. Well be referred to as the sliver spread market makers can create?
Determinant factors for Haircut Amount
Primarily, price and lower associated risk are obtainable for a haircut. But if the lender certainly desires that the. Whole loan will be covered if the collateral is liquidated. A haircut is negligible if the determinant. Factors such as a high degree of certainty on the value. Credit value, and liquidity of security are certain.
Thus, assets characterized by price uncertainty and. Volatility carry larger haircuts when used as collateral. For instance, in a scenario where an. Investor seeks to borrow a fund from a brokerage by. Posting equity positions to a margin account as collateral, he can only. Borrow 50% of the value of the account as a. Result of price uncertainty (haircut).
Haircut in Market Maker Spreads
Secondly, we stated earlier that a haircut is sometimes. Referred to as the market maker’s spread. For the fact that market makert. Can transact with low transaction cost and razor-thin spread, they are likely taking. A small haircut of profit or slivers constantly all day long.
Nowadays, the market has become unusual and efficient, thus, spreads in many assets have reduced to haircut levels because of the determinant factors involved. This applies that retailers will have to transact at the same spreads the market makers do. But retail traders always have higher costs, making trading the spread ineffective.
Long-Term Capital Management’s Failure and Collateral Haircuts
LTCM has had massive losses as a hedge fund firm which has nearly resulted to the collapse of their financial system. The aim of LTCM was to suck up small profits from market inefficiencies. However, this act is generally known as Arbitrage, by using historical models to generate opportunities and then release capital to profit from them. In return, each opportunity produced a small amount of profit, so they slide on to utilize leverage to increase the gains.
The failure of the LTCM financial system required a bailout which resulted as a result of much higher haircuts rules in regards to what can be posted as collateral and the amount the haircut should be.
NOTE: Till today, TCM had no haircuts basically, but still, the average investor buying regular stocks is put through a 50% haircut if those stocks are used as collateral against the amount borrowed on a margin trading account.