In the financial industry, a haircut is a value reduction made to an asset in order to determine the capital requirement, margin, and level of collateral. It is the difference between a loan's principal and the asset's market value that will serve as collateral. This amount is given as a percentage. The lender must take into account the shifting market price over time, which results in the difference.
The difference between the purchase and sale price of a stock, bond, derivative contract, or any other financial instrument is also referred to as a haircut.
When a financial institution or lender assigns a value to a collateral asset that is less than the requested loan amount, this is known as a haircut. The lender chooses the haircut amount, which varies depending on the institution and situation and is typically expressed as a percentage difference. The amount of the haircut is determined by weighing the risks. If the borrower defaults, the lender must take into account the level of risk they would run if they were unable to sell the asset or collateral for a high enough price.
Another unusual financial application of the term "haircut" is in debt restructuring. A haircut, specifically in the context of debt restructuring, is the considerable reduction of unpaid bond principal or interest obligations. The phrase is the market's euphemism for wiping out a sizable portion of the debt owed to the creditors. The term "haircut" came to mean, more specifically during the Eurozone crisis and in particular in the context of the Greek financial crisis, that holders of state debt received less than par.
Consider a scenario in which a bondholder owns a zero-coupon security with a face value of $1,000, but the issuer later agrees to repay only $400. This suggests that the investor will take a $600 loss. Receiving less than what was due is referred to as "taking a haircut."
When a bank "haircuts," it accepts less than what was owed on a specific loan account. As an illustration, if a borrower owed a bank $10,000 and it agrees to only take back $8,000, it takes a 20% haircut. When there is little chance that an account will recover fully, banks take this action. Banks occasionally opt for less rather than losing all the money or allowing an asset to gradually lose value.
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