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What is Haircut in Stock Market?

What is Haircut in Stock Market?

Haircut meaning in share market, signifies the percentage difference between the market value of an asset and the limit granted against it as collateral. It's a deduction applied when setting limits on investments. In the stock market, haircuts act as safeguards for lenders, protecting them from losses in case of price drops. For instance, if you pledge shares worth ten lakhs, and the lender allows a limit of 9.50 lakhs, the haircut becomes crucial. The lender's risk is mitigated if the stock falls by 20%. Various factors influence haircuts, including price, volatility, credit quality, liquidity, and secondary market value. Understanding this concept is vital for risk management in trading and investing.

How do you Calculate Haircut Value?

A haircut is determined by deducting the lender's recognized value of collateral from the market value of the collateral asset. Here is the formula for calculating a haircut: 

Haircut = Market value of the collateral asset – Value of the collateral asset recognized by the lender

Typically, a haircut is expressed as a percentage:

Haircut (%) = (Market value of the collateral asset – Value of the collateral asset recognized by the lender) / Market value of the collateral asset. 

This formula provides a clear and systematic way to calculate the haircut percentage, considering the difference between the market value and the value recognized by the lender.

Consider this Example of a stock market haircut. Suppose Sarah seeks a loan of ₹800,000, offering her equity portfolio valued at ₹800,000 as collateral. Due to price uncertainty risk, the lender values the portfolio at ₹480,000, resulting in a ₹320,000 or 40% reduction, which constitutes the haircut. 

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Table of Content

  1. How do you Calculate Haircut Value?
  2. Factors Affecting the Value of Haircut 
  3. Key Features of Haircut in Stock Market

Factors Affecting the Value of Haircut 

The following factors affect the value of haircuts in the share market:

  1. Borrower's Creditworthiness

    To determine if the borrower will be able to repay the loan, the lender checks the borrower's creditworthiness. A lender might check the borrower's income, payment history, credit score, etc. A lower haircut percentage will be offered if the borrower has good credit, and vice versa.

  2. Asset Risks

    Risk is one of the biggest factors in determining collateral value. Lenders may think about the risk of not being able to sell collateral assets at enough price if the borrower defaults.

    Also, collateral assets like T-bills, bonds, etc., have lower haircut values since they have a lower risk. However, if the asset is high risk and price uncertain, like equity shares, the haircut percentage may be higher.

  3. A collateral's liquidity

    Liquidity is how easily and quickly an asset can convert into cash. In case of default, a lender can sell a collateral asset for a fair price and get cash quickly if it is highly liquid. Conversely, a lesser liquid collateral asset would have a higher haircut.

Key Features of Haircut in Stock Market

After understanding what is a haircut in the stock market, let’s explore some key features of haircuts in the stock market:

  • The haircut value in the stock market varies according to the risk level associated with each asset class. Higher-risk assets have greater haircut values, and vice versa.
  • Generally, equities have a higher haircut than gold or debt in the stock market.
  • Lenders impose haircuts to safeguard themselves in case customers fail to repay. For instance, if you have Rs. 5 lakhs worth of margin pledged shares, you may receive Rs. 4.5 lakhs after deducting the haircut. This reduction acts as a protection for the lender in case of a 20% drop in share price.
  • The haircut in the stock market is based on market conditions, liquidity, and volatility. For instance, during periods of high stock market volatility, banks or lenders may increase the haircut to protect their interests.

Conclusion 

In the share market, a "haircut" signifies the percentage difference between an asset's market value and the collateral limit. This risk management measure safeguards lenders in market downturns, which is vital for stability. Factors such as asset class risk, borrower creditworthiness, asset liquidity, and market conditions influence haircut values. For traders and investors using a online trading app, comprehending the concept is pivotal, affecting borrowing limits and overall portfolio risk management. Haircuts are indispensable for maintaining stability and minimizing risk in the lending and overall market landscape.

FAQs on Haircut in Stock Market

A haircut is when a bank accepts less than what's due for a loan. The bank would take a 20% haircut if the borrower owed it Rs 10,000 and it only agreed to take back Rs 8,000.

In debt restructuring, a "haircut" refers to the reduction in the face value of a debtor's outstanding debt.

Risk-based haircuts in finance refer to the reduction of an asset's recognized value below its current market value. Risk-based haircuts occur when a lender devalues an investor's securities used as collateral for a loan.

The haircut percentage in NSE is 10%.

Exchanges define haircut value for equities, and banks have their own practices for determining haircut value.