When you google the word haircut, you can find all kinds of hairstyles recommend by Youtubers or bloggers. A perfect haircut can make you totally different. Some people choose to cut their hair to welcome their new life.
However, in economics, haircut has a different meaning.
For example, when you take a loan for business from a bank, the bank may ask you something for collateral. Let’s say you need $10,000. You prepare $10,000 stock portfolio as collateral. Usually the bank will not recognize the stock portfolio as $10,000, they will give you a discount. Suppose the bank thinks your stock portfolio is only worth $6,000 in collateral. The $4,000 or 40% reduction in the asset’s value, for collateral purposes, is called the haircut.
A haircut is the percentage difference between an asset’s market value and the amount that can be used as collateral for a loan. Because market values change from time to time, the lender needs a cushion to avoid risks as much as possible.
The larger the risk is perceived to be, the larger the haircut will be.
So, what factors can influence the haircut amount?
Generally speaking, lower risks result in compressed haircuts. Because the lender is ensured that the full amount of the loan can be covered if the collateral is liquidated.
For example, the US Treasury bills are often seen as safe assets, which may have a haircut of 10%. Other assets like stocks or funds, which are seen as highly risky due to the uncertainty in the stock market, may have a haircut of 30%. In other words, a $1,000 treasury bill will be accepted as collateral of $900, while a $1,000 stock may only worth $700.
Market is changing every now and then. Assets that we have might be appreciated or depreciated. When we take a loan and use collateral, we should pay special attention to the haircut, making sure that the assets are of low haircuts and maximize our profits.