What is Haircut in the Stock Market?
As a trader in the stock market, you need to be familiar with the phrase “haircut”. A haircut comes into the picture when the exchange or lender cannot credit you for the full value of the shares. Following the haircut in the share market, you will receive credit. So how is the worth of this haircut determined? An exchange or lender takes a lower value when they see the assets as collateral. The haircut value is the lesser value. Equity, for example, might have a 50% haircut, whereas debt and gold might only have 20% and 10% haircut values, respectively. The kind of asset you offer as collateral in the stock market determines your haircut. Let’s look into what a share market haircut means and more.
Key Highlights
- A haircut in the stock market refers to the percentage difference between an asset’s market value and the amount that can be used as collateral for a loan.
- It’s a risk management tool lenders use to create a safety buffer against potential market fluctuations.
- The size of the haircut typically depends on the asset’s volatility and liquidity; riskier assets usually have larger haircuts.
- In margin trading, haircuts determine how much can be borrowed against securities, affecting leverage potential.
- Haircuts can change based on market conditions, potentially triggering margin calls if they increase significantly.
Table of Contents
Understanding Collateral Haircut
A haircut in the stock market reduces the market value of an asset used as collateral for a loan. Due to the lending parties’ need for safety, securities are generally devalued when used as collateral if the market value falls.
If a borrower defaults, the lender may have to sell the collateral, affecting its value. Moreover, depending on the risk associated with the collateral, the haircut amount will vary. The amount of a haircut can be influenced by several factors, including the price, volatility, the credit quality of the asset’s issuer (if applicable), and the collateral’s liquidity risks.
What Determines the Haircut Amount?
Now that you know what haircut is in the share market, let us discuss what determines it. The stock exchange broadly defines the haircut value of an asset class. However, the lender has the final say in deciding the haircut, provided they adhere to the boundaries set by the exchange. In India, stockbrokers and banks generally act as lenders.
The lender evaluates the assets based on the nature of the asset. They consider how risky the asset is. The lender gauges the risk factor based on factors like the liquidity and volatility of the asset. They also consider the prevailing sentiment and market conditions. If the asset carries more risk, the asset will have a higher haircut value. Conversely, if the asset is classified as a less risky asset, it will have a lower haircut.
For instance, riskier assets like stocks may have a 50% haircut value. At the same time, bonds that are less risky than stocks may have a haircut of 30%. This is because stock prices are volatile compared to bonds. The value of a stock could plummet by 20% or even more if the market perception changes towards that stock. However, there is no default risk, and bonds guarantee regular interest payments. The only variable with bonds is the rate of interest.
There are good times in the market where financial assets like stocks seem very lucrative investments. During these times, stocks tend to be relatively less volatile. Many investors enter the market to invest and trade, which helps maintain high liquidity. On the flip side, when uncertainty and fear persist in the market, many investors avoid those stocks and prefer investing in assets like bonds. During these times, the stocks are very volatile. So if the market conditions and sentiments are positive, the haircut of a particular stock may be relatively less than it would be during uncertain times.
Features of a Haircut in the Stock Market
The features of a haircut in the stock market are as follows:
- The lender determines the haircut based on the risk associated with the asset.
- Assets with high volatility have a high haircut. Assets with low liquidity also have a high haircut.
- The haircut value will change with the changing market conditions.
- The haircut functions to protect the lender from incurring a potential loss.
What is the Difference Between Haircut and Repo Rate?
A haircut is a percentage reduction in the value of a collateral asset. When a borrower offers an asset as collateral, the lender assesses the risk associated with that asset and may apply a haircut. Lenders apply haircuts to protect from potential losses if the collateral needs to be sold if the borrower defaults. Additionally, an asset with a higher perceived risk will have a higher haircut.
The repo rate is the interest rate at which central banks lend money to commercial banks in exchange for government securities (usually bonds). Central banks use it to manage inflation and control the money supply.
A higher repo rate makes borrowing money from the central bank more expensive and can affect other economic interest rates. Additionally, the repo rate is crucial in determining short-term interest rates in monetary policy.
Key Differences Between Haircut and Repo Rate
Here is the key difference between Haircut and Repo Rate:
| Basis | Haircut | Repo Rate |
| Meaning | Amount of reduction in collateral’s value | The interest rate at which central banks lend money against collateral |
| Purpose | If the collateral value decreases, the lender is protected from potential losses. | It manages inflation, controls the money supply, and determines short-term interest rates. |
| Application | Lenders use this when accepting collateral for loans. | Central banks set these up to lend to financial institutions. |
| Risk | Reflects the perceived risk associated with the collateral. | Reflects monetary policy objectives and economic conditions. |
| Impact on borrowing | Reduces the amount of funds that can be borrowed against collateral | Affects the cost of borrowing for financial institutions and other interest rates |
Conclusion
The amount you receive when selling shares minus the asset’s market value is known as the haircut. It fluctuates based on the type and volatility of the collateral. Thus, the next time you use your stocks as collateral, be careful to confirm the haircut value. Due to this, you will be able to understand the exact limit that will be placed on your collateral.
FAQs on Haircuts in the Share Market
A margin and a haircut are the same thing in essence. The value of the collateral is determined by both of these factors, which are frequently less than the total amount of the loan or collateral. A haircut is frequently described as a decrease in the collateral's value. The collateral ratio, or percentage of the purchase price, is a common way to express the margin.
The exchange defines haircut value widely in the case of stocks, and banks also use internal procedures to calculate haircut value.
In debt restructuring, a haircut refers to a decrease in the bond's principal or unpaid interest.
The haircut rate in the stock market is the percentage that deducts an asset's market value from the total amount that can be used as collateral to obtain a loan. Lenders use this risk management tactic to protect themselves from potential losses in the event of a borrower's failure.
Higher haircut rates are typically applied to stocks with higher volatility. This is because lenders need a bigger buffer to guard against possible losses. After all, volatile stocks are more likely to experience abrupt price decreases. Blue-chip stocks generally have lower haircut rates because they are less volatile.