Haircut

What is a Haircut?

Basically, a haircut can have two different meanings. Most commonly, it is referred to the percentage difference between the Market value and the amount to be used as a Collateral of an asset for a loan.

There is a significant difference between these two values because the market prices keep changing over the period of time, which the lender has to accommodate. For instance, if you need an Rs. 10,00,000 loan and want to use Rs. 10,00,000 stock Portfolio in the form of the collateral, the Bank will consider the Rs. 10,000,00 worth of the portfolio as Rs. 5,00,000 in collateral. This 50% reduction in the value of the asset, for the purpose of collateral, is known as a haircut.

Explaining Collateral Haircut

A haircut is known as the lower-than-market-value that is placed on the asset being used in the form of collateral against a loan. The haircut is generally expressed as the markdown percentage between two different values.

When used as collaterals, generally securities get devalued, considering that a cushion is needed by the lender in case the market value decreases. When the collateral is kept ahead, the haircut degree is comprehended by the amount of risk that the lender will be carrying.

These risks comprise any variables that might leave an impact on the collateral’s value in case the lender has to sell the security in a situation where the borrower goes Default. Variables that may leave a significant impact on the haircut’s amount include liquidity risks of the collateral, Volatility, price, and the credit quality of the issuer of the asset (if available).

Example of Market Maker Haircut

In several markets, the market maker’s spread is regarded as similar to that of the retail trader’s spread. However, the trading costs for the retail trader may render the profit from the haircut spread ineffectively.

One such market where the retail traders generally cannot trade at similar spreads in comparison to the market makers is the forex market. The reason behind is that the forex brokers generally mark-up the spread; thus, this helps them make money.

In the forex pair of EUR/USD, the raw spread that is available to the market maker is 0.00001. Still, retailer traders may end up paying a spread anywhere between 0.00005 to 0.00015 or higher, which is the mark-up of 5-15 times the raw spread.

Hence, forex brokers who provide raw spreads to their clienteles charge a significant amount in the form of a commission on every trade. Instead of marking-up the spread, the brokers make their money from trading fees.