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A “haircut” is a reduction which is applied to the value of an asset. Typically, “haircuts” are expressed as a percentage. For example, if a “haircut” of 5% were applied to bonds worth GBP 100, it would mean that the bonds would be treated as if they were only worth GBP 95 for the purposes of the relevant transaction.
“Haircuts” are designed to act as a collateral ‘cushion’ in certain types of finance transactions. For example, a lender would be unlikely to lend GBP 100 in cash against collateral in the form of bonds worth GBP 100. The reason for this is that the bonds themselves are liable to fluctuate in value. If the bonds were to FALL in value, there would be insufficient collateral for the lender to ‘make itself whole’ in the event that the borrower defaulted. As such, the lender might apply, say, a 5% haircut to the value of the bonds – valuing them at GBP 95 for the purposes of the transaction (even though they were still worth GBP 100 in the real world). In these circumstances, the value of the bonds could fall by up to 5% and the lender would still retain sufficient collateral to protect itself from loss in the event of a borrower default.
The size of a “haircut” is largely a function of two factors:
- The VOLATILITY of the asset in question – in other words, the tendency it has to experience price swings. All other things being equal, the HIGHER the volatility of an asset provided by way of collateral, the LARGER the “haircut” that will be applied to that asset.
- The MATURITY of the asset in question – in other words, the amount of time remaining before the asset is redeemed. All other things being equal, the SHORTER the maturity, the SMALLER the haircut and the LONGER the maturity, the LARGER the haircut.