What Is Haircut In The Stock Market With Example?

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 haircut meaning in share market concept is vital for risk management in trading and investing.

How To Calculate Haircut Value?

A haircut in trading  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.

After understanding what is haircut, here is the 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. 

Factors Affecting the Value of Haircut

The following factors affect the value of haircut in 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. Collateral 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 haircut in 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.

What Is Pledging? 

Making a promise or lien against an asset is called pledging. Banks require that an asset be given as collateral for any loan. You grant the bank or lender a lien on the asset, giving them the right to sell it to recoup debt should you fail to pay the principal, interest, or EMI. This holds for all types of assets, such as bonds, stocks, mutual funds, real estate, etc.

The pledger accepts the loan and pledges the asset. The pledgee is the lender who agrees with the assets as security.

Conclusion
Understanding haircuts in the share market is crucial for effective risk management in trading and investing. Haircuts protect lenders by reducing losses if asset prices decline. Calculating haircut values helps lenders determine the appropriate limit against collateral. Factors like asset risk, liquidity, and borrower creditworthiness influence haircut percentage. Higher-risk assets attract higher haircut values to compensate for uncertainty. Understanding haircuts helps investors and lenders navigate market risks more effectively, fostering a more secure financial environment.