What Is Meant By A Haircut In A Collateral Agreement

Lower reductions allow for higher leverage. Haircut plays an important role in many types of transactions, such as pension transactions (called “repo” in debt financing, but not to be confused with the concept of withdrawal that this term refers to in consumer financing) and reverse repo transactions in debt instrument financing). In financial markets, a haircut refers to a reduction in the value of an asset. It is expressed as a percentage. For example, if an asset – such as owning a particular government loan – is worth one million euros but receives a 20% discount, it means that it is treated as if it were worth only 0.8 million euros. Lenders must consider the risk to which they would be exposed if they did not sell the collateral for sufficient money after the borrower defaulted. Less associated risks and greater accuracy of price predictability result in fewer discounts. For example, if a lender is hopeful of recovering all the credit when the security is sold, the haircut will be lower. A haircut can also be described as a difference between the purchase price and the selling price of a stock share, a loan, a futures contract or an option contract or other financial instrument. The difference is usually the processing fee for the transaction. The failure of the LTCM, which required the rescue of the financial system, led to much higher discount rules regarding what can be reserved as collateral and the amount of the haircut. LTCM did not actually have a discount, but today, an average investor who buys common shares is subject to a 50% discount if he uses these shares as collateral against the amount borrowed from a margin trading account.

A haircut is based on loan risk. These risks include factors that could lead to a loss of security value and the risk of borrower default. Some of the variables that affect the amount of haircut are explained below; Die Hàhe des Haircuts h-ngt auch davon ab, wie liquid e.A. die Sicherheiten sind. If the asset is highly iliquide, then it will be easy to sell it quickly without loss of value. A smaller reduction is therefore introduced. A much more difficult asset to sell for fair market value will bear a larger discount.