Haircut in Finance |
| Credit: Corporate Finance Institute |
Not the one which you are thinking
The term haircut in finance is most commonly used when referencing the percentage difference between an asset's market value and the amount that can be used as collateral for a loan. There is a difference between these values because market prices change over time, which the lender needs to accommodate
Let's Understand
• A haircut refers to the lower-than-market value placed on an asset being used as collateral for a loan. The haircut is expressed as a percentage of the markdown between the two values.
• When they are used as collateral, securities are generally devalued, since a cushion is required by the lending parties in case the market value falls.
• When collateral is being pledged, the degree of the haircut is determined by the amount of associated risk to the lender. Simply put, the riskier the deal, the more is the hair cut.
Example
For instance, say a if a person needs a $100,000 loan and wants to use their $100,000 house as collateral, the bank is likely to recognize the $100,000 portfolio as worth only $85,000 in collateral. The $15,000 or 15% reduction in the asset's value, for collateral purposes, is called the haircut.
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