Haircut has a different meaning in the stock market. You may come across the phrase “haircut” when you first begin your financial journey. So let’s talk about the haircut in the stock market. You should learn about it, if you are going for a trading account opening to enter the share market. We shall take an in-depth look with suitable illustrations. When determining the minimum capital, margin, and level of collateral, a haircut is the decrease made to an asset’s value. In other words, it is the difference between the loan amount and the market value of the item pledged as loan security. In terms of a percentage, it is the drop in value.
The loan-to-value ratio and a haircut make up 100% when put together. Hence the complement of the ratio is also known as a haircut. For instance, central banks often need collateral when they lend money to private banks. The collateral’s value will be reduced as a result of the haircut. A loan for Rs. 50,000 could only be secured by an asset with a market value of 50 lakhs if it had a 40% haircut. The lender gets some risk protection, to guard against reductions in market value by depreciating the assets pledged as collateral. The amount of loan-related risk determines the haircut’s level. By taking into account all potential causes of decline in collateral’s value, the amount of risk is established.
Factors Affecting Haircuts
Interest rates, creditworthiness, and the liquidity of collateral are the factors affecting the amount of haircuts. The percentage of haircuts differs because market rates change over time. The lender must take this into consideration. In other words, the amount of associated risk to the lender at the time the collateral is pledged will determine the haircut value. The value of the haircut increases alongside risk, and vice versa. In some instances, the market maker’s spread in the share market also uses the haircut.
Example of Haircut
The haircut amount is used to protect the lender’s interest. The lender will lose a lot of money if the stock declines 20% on the stock exchange. For example, if you pledge Rs. 15 lakh in securities and the lender gives you Rs. 11.50 lakh. A haircut was used in the stock markets to cover these risks. There may be threats to the borrower’s ability to repay the loan. These include elements that could affect the collateral’s value if the creditor needs to sell it. The factors that affect the haircut in finance include price, volatility, creditworthiness, asset liquidity, and secondary market value.
Significant Points to Note
- An investment receives a haircut, when it is pledged as security for a loan. The risk of the actual asset mostly dictates how much of a haircut will be applied.
- Riskier investments are subject to higher haircuts.
- Market makers may create spreads that resemble silver haircuts or vice versa, often known as haircut finance.
- Haircuts always change, as changes in the type of investment have an impact on them. To protect the lender’s investment, the bank may increase the haircut on frontline shares if they become too risky.
How To Examine Haircuts In The Stock Market
The risk factor in haircut is higher compared to other investments. Government bonds have no default risk along with guaranteed repayment and interest. The only potential danger is an increase in interest rates, which would lead to high collateral values and low haircuts. However, the equities markets are incredibly volatile which can cause disproportionate haircuts. Therefore, securities with higher volatility and price fluctuations will have higher haircuts when used as collateral. The normal stock haircut, both in the Indian and worldwide contexts, is around 50%.
Share Pledging: It is a strategy used by business owners to get loans for operating capital, new initiatives or acquisitions. A promoter’s ownership stake in a company is used as collateral for loans. Promoters maintain ownership after committing shares. Nevertheless, the value of the collateral varies along with the stock’s value.
Margin Call: A margin call happens when the price of the shares pledged to a lender falls below a certain threshold. So, the promoters have to cover the shortfall in the value of the collateral.
A haircut is the difference between the market value of an asset and the amount that can be used as collateral for a loan is known as a haircut in the stock market. Many reputed firms provide lending facilities to cover the haircut. All you have to do is to open investment accounts with them. Just open your trading account on the online share market app of firms like Share India. You can avail all kinds of trading facilities at minimal charges only.