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Have you pledged shares as collateral only to find you can’t borrow their full value? The difference is called the ‘haircut’. It acts as a risk buffer for lenders against market fluctuations.
In this article, we will decode haircuts, the key factors affecting percentages, and their features in the stock market. Get to know the factors that influence haircut amounts in your portfolio. Let’s begin!
What is a haircut in the share market and how does it work?
The term “haircut” in the stock market describes the decline in asset value while determining the margin, collateral level, and capital need. In simpler terms, it is the difference between the loan amount given and the asset’s market value that is used as collateral for the loan. The value drop is shown as a percentage.
The percentage here represents the gap between the asset’s current market value and the limit you may receive against the collateral.
For example, if the haircut is 20% and your pledged shares are worth ₹1000, you will get credit for ₹800. This provides the exchange or lender with a safety net of ₹200 if the share price drops or you cannot repay the loan. The smaller the haircut, the less risk there is for the lender or exchange, and the lower the credit you receive.
On the other hand, a collateral haircut is when something is used as collateral for a loan, and its value is lowered below its market value. When collateral is put up as security, the haircut amount depends on the risk the lender takes.
If the borrower defaults on the loan, the lender may have to sell the collateral to cover the loss. Any factor that might reduce or increase the value of the collateral is considered a risk. Several factors might affect the haircut amount, such as the asset’s value, fluctuations, issuer credit quality, and collateral issues related to liquidity.
A glance at pledging
The term “pledging” describes using an asset to secure a loan. If you default on a loan, the bank or lender may seize the collateral you pledged as security. Anything, from stocks and bonds to property and funds, may be considered an asset.
Whoever uses the collateral to secure the loan is known as the pledger. It is the pledgee who provides the loan and receives the asset.
Features of haircuts in the share market
The haircut value varies from one asset class to another since it is proportional to the inherent risk of each asset type. As a result, the haircut value is directly proportional to the risk level. Compared to gold and debts, the haircut for stocks is often higher.
The haircut safeguards the lender when a borrower fails to repay a loan. Let’s say you have used shares worth ₹10 lakh as collateral for a loan. The lender has applied a 10% haircut, which means they have reduced the value of the shares by 10%. So, they have given you a loan of ₹9 lakh, which is 90% of the value of the shares.
And if the stock price drops by 20%, your lender or broker may have suffered a loss since the share price is now ₹8 lakh. In these situations, a haircut is used to safeguard the lender.
If the asset’s fluctuation, liquidity, or market conditions change, the haircut will adjust accordingly. For instance, if the volatility of a stock has reached a certain point, the lenders may decide to raise the haircut on that specific asset class.
What are the variables affecting the amount of haircut?
Some of the variables affecting the amount of haircut are:
Identifying the asset type:
When it comes to risk and liquidity, each asset is different. Haircuts are higher for assets that are riskier and less liquid. As an example, haircuts for stocks are greater than those for cash. It is because cash and government bonds are low-risk and easy to sell. However, stocks and commodities have high haircuts due to their increased risk and limited liquidity.
The rate of interest:
A higher haircut is associated with a higher interest rate. This is because interest rates indicate the potential cost of lending and borrowing. When the interest rate is high, the lender expects a significant profit with little risk.
The borrower’s credibility:
The borrower’s creditworthiness determines the haircut. The reason is that creditworthiness determines the borrower’s capacity and intention to pay back the loan. The lender is more likely to experience default and loss if the borrower has poor creditworthiness.
Risks related to the collateral’s liquidity:
Liquidity risk evaluates how quickly and easily the collateral may be sold. A high liquidity risk indicates that the lender faces the possibility of not being able to get back the loan amount by selling the collateral at a reasonable price.
Conclusion
In short, haircuts in trading serve as a cushion for lenders against volatility and liquidation risks for pledged shares.
Knowing the variables that impact haircut percentages can help retail investors better evaluate funding offers against their portfolios.
FAQs
A 20% haircut means that the lender or the exchange will give you credit for only 80% of the market value of your asset that you pledge as collateral. For example, if you pledge shares worth ₹1000, you will get credit for ₹800 after a 20% haircut.
Haircut is calculated as the percentage difference between the market value of the asset and the limit you receive against it. The formula is: Haircut = (market value – limit)/ market value * 100
Pledging shares can be a good way to get additional funds for trading or investing without selling your holdings. However, it also involves some risks; for example, the lender may sell your shares if you fail to repay the loan or meet the margin requirements.
Yes, you will get a dividend if you pledge shares, as the ownership of the shares remains with you. However, you may not be able to access the dividend amount until you unpledge the shares, as it may be credited to the lender’s account.
A haircut in finance is directly tied to risk. A haircut in risk is the reduction of an asset’s value below its market value when used as collateral. It is a risk management technique to protect the lender from potential losses if the asset price falls or the borrower defaults.