A haircut is a term used in finance to describe the difference between the market value of an asset and the value at which it can be used as collateral. A haircut is applied to collateral to account for the potential decrease in value of the asset over time, or to protect the lender in case of default.
In the context of securities lending, a haircut is the difference between the market value of a security and the value at which it is loaned out. For example, if a stock is trading at $100 and a lender is willing to loan it out at $90, the lender is said to be taking a 10% haircut on the value of the stock.
In the context of margin trading, a haircut is the difference between the market value of a security and the value at which it is used as collateral for a loan. For example, if a stock is trading at $100 and is used as collateral for a loan at $90, the lender is taking a 10% haircut on the value of the stock.
A haircut helps protect the lender by providing a cushion against potential losses in the value of the collateral. The higher the haircut, the lower the risk for the lender, but also the lower the amount of leverage that the borrower can use.
It’s important to note that haircut is a mechanism used by financial institutions to mitigate their risk, and it can vary depending on the type of assets, the market conditions and the lender’s risk appetite. Additionally, haircuts can change over time, as market conditions change, and the lender may adjust the haircut accordingly.