What is a risk-based haircut?
Risk-based haircut refers to reducing the recognized value of an asset below its current market value by using security as collateral. It is applied to various securities such as stocks, futures, options, and the likes.
What does a risk-based haircut do?
A risk-based haircut seeks to measure the probability of an asset falling below its current market value, thereby helping establish a sufficient buffer to protect the investor against margin calls. A margin call is when an investor is asked to deposit more money in the brokerage account or sell the assets held in the account in a proportion that the margin available is sufficient for the assets held.
Decoding risk-based haircut
It is a critical step that helps prevent the margin call or any such over-leveraged position in the portfolio of an investor/trader. A margin call is generally raised when the value of the investor’s margin account falls below the broker’s required amount, thereby requiring the investor to either deposit money in the brokerage account or sell securities to bring below the portfolio value.
Let us understand from a simple example. When an investor uses security as collateral when borrowing money, the lender tends to devalue the securities by a certain percentage to get the cushion if the market value of the securities falls. This amount depends on the kind of security and the risk involved. Higher is the risk; higher is the devaluation. This percentage of value reduction is called a risk-based haircut.
The haircut is generally expressed as a percentage of the collateral’s market value. For example, a risky asset (stock) may be worth Rs 100/ per share. It may receive a 50% haircut and be valued at Rs 50 if used as collateral.
What Determines the Haircut Amount?
One of the primary determinants of hair is the borrower’s default risk. Additionally, various aspects may lead to a drop in the collateral value. For example, one could measure the risk associated with the asset (for example, standard deviation measures the risk associated with an asset and maybe a good indicator to determine haircut).
A lender needs to assess the ability of the lender and the value that can be recovered if the borrower defaults on it. If the lender believes that the asset is highly liquid and the value is not very volatile, the hair cut will be very low; otherwise, the hair tends to increase as the lender’s capital risk increases. In the case of stocks, generally, blue-chip stocks have low haircuts, whereas penny stocks have very high haircuts as the latter is very volatile and is highly illiquid.
Haircut in banking
Haircut in banking, mainly on loans, is determined based on the borrower’s creditworthiness. The borrower’s probability of default on a loan is the direct metric for the haircut.
What is pledging?
Pledging is creating a lien on an asset. For example, when a bank or a financial institution provides a loan, they insist that an asset be pledged along with the loan as security. A lien on an asset provides the lender with the right that if you (borrower) default on the lender’s obligation (EMI or the principal), the lender has all the authority to liquidate the asset to recover its dues. This applies to all the assets, including equities, real estate, gold, etc.
The borrower or pledger is the person who pledges the asset and takes the loan, and the lender who takes the asset as a pledge is called the pledgee.
What is a loan against shares?
One of the ways of using Demat holdings to get money is to avail loan against shares. In this model, you tend to borrow money from a lender (a bank or other financial institution), which pledges your holdings and provides you with a loan. During the process, the lender evaluates every security in the portfolio, and depending on liquidity and price risk of the security, a haircut is applied to each stock. After the haircut, the final value provided as a loan is determined, and the application is processed.
Some frequently asked questions
What is a risk-based haircut?
The risk-based haircut is the practice of determining haircuts based on the risk involved in an asset concerning liquidity and volatility in the price. Generally, equity has a higher haircut at 40-50%. Within equity, bluechip has lower hair cut when compared to a penny stock.
Who determines haircut value?
Haircut value is defined by the exchange in the case of equity and banks in the case of loans.
What is a spread?
Spread is another meaning of haircut, and it is the difference between the bid and the ask price that the market maker earns when making markets in various assets.
A risk-based haircut is a method in which a haircut is determined based on the associated risk of the asset. It is used for all asset classes such as equities, mutual funds, futures, options, real estate, etc. Higher is the risk of an asset in terms of liquidity and price; the higher is the haircut. A risk-based haircut allows the lender to be safe regarding the probability of default on a loan advanced against the security. Also, the risk-based haircut allows a broker to raise margin calls accordingly with the investor where there is a change in the portfolio’s overall risk and associated margin requirement against the portfolio.