What Is Meant By A Haircut In A Collateral Agreement
Lenders must ensure that the money they lend is repaid. The greatest security, of course, is an agreement with the borrower. However, if the borrower does not repay, the lender must sell the collateral. Thus, the lender must ensure that it is able to sell the collateral at a price sufficient to cover the loan. A haircut refers to the value less than the market value placed on an asset used as collateral for a loan. The discount is expressed as a percentage of the discount between the two values. When used as collateral, securities are generally devalued because the lending parties require a cushion in the event of a market value incident. A haircut has two meanings. The term discount is most often used to refer to the percentage difference between the market value of an asset and the amount that can be used as collateral for a loan.
There is a difference between these values because market prices change over time, which the lender must take into account. For example, if a person needs a $10,000 loan and wants to use their $10,000 stock portfolio as collateral, the bank will likely recognize the $10,000 portfolio as collateral for only $5,000. Reducing the value of assets by $5,000 or 50% for secondary purposes is called a discount. Typically, price predictability and reduced associated risks result in compressed discounts, as the lender has a high level of certainty that the full loan amount can be covered if the collateral is to be liquidated. For example, treasury bills are often used as collateral for overnight loan agreements between government securities dealers called repurchase agreements (rest). In these agreements, discounts are negligible due to the high level of certainty about the value, credit quality and liquidity of the security. In many markets, the market makers` spread is the same as the retailer`s, although the trading costs make it inefficient for the retailer to try to take advantage of a discount spread. A haircut is sometimes called a market-grade`s spread. Because market makers can trade with very thin spreads and low transaction costs, they can take small splinters or discounts on profits (or losses) throughout the day. Central banks must ensure that the money they lend will be repaid.
The first line of defense, of course, is the agreement with the borrower on repayment. But if the borrower does not repay the loan, the central bank will sell the collateral. He must therefore be sure that he will be able to sell the guarantee at a price that covers the amount of the loan. But assets can rise and fall in value, and central banks may need some time to sell certain assets…