Last Updated: Mar 21, 2024 Value Broking 8 Mins 1.7K

New investors will be scratching their heads when they first encounter the term ‘Haircut’ as they learn about the stock market. The stock market has plenty of jargon, and the term haircut is one of them. However, knowing the meaning and understanding such jargon will only help you become a more successful investor, which is why it will only benefit you to know what haircut is in the stock market.

There may be a lot of questions in your mind like what is a haircut in the stock market? What is a haircut in the share market? What is the meaning of a haircut in the share market? This article will help you understand what a haircut in the share market means.

The term haircut has two meanings for investing and the stock markets. This article will cover the more common usage of the term. The common usage of the term haircut associates itself with the term collateral. Collateral refers to assets a lender accepts as security for a loan. Investors can borrow funds from their broker to invest or trade financial instruments in the share market by offering the stocks or other financial instruments they own as collateral. Now, getting back to the term haircut, a haircut is the percentage between the asset’s market value and the value it retains when offered as collateral.

Let us understand what a haircut is in the stock market with examples. For instance, an investor may have a portfolio of stocks worth rupees 5,000. However, the investor has come across a strong trading setup but is short on funds to carry out the trade. In this case, the investor can borrow money from their broker. In exchange, they offer their entire stock portfolio as collateral. However, as collateral, the lender only values the stock portfolio at rupees 2,500. As collateral, it is half its market; it retains only 50% of its market value. This 50% reduction of the stock portfolio, for collateral proposes, is the haircut. The haircut may differ from asset to asset depending on how the lender looks at the assets.

Understanding Collateral Haircut

A haircut in the stock market is a reduction of the market value of an asset used as collateral for a loan. Due to the lending parties’ need for safety, if the market value falls, securities are generally devalued when used as collateral.

The lender may have to sell the collateral if a borrower defaults on the loan, affecting the collateral’s value. Moreover, depending on how much risk is associated with the collateral, the haircut amount will vary. The amount of a haircut can be influenced by several factors, including the price, the volatility, the credit quality of the asset’s issuer (if applicable), and the collateral’s liquidity risks.

What Determines the Haircut Amount?

Now that you know what haircut is in the share market let us discuss what determines the haircut in the share market. The stock exchange broadly defines the haircut value of an asset class. However, the lender has the final say in deciding the haircut, provided they adhere to the boundaries set by the exchange. In India, the stockbrokers and banks generally act as lenders.

The lender evaluates the assets based on the nature of the asset. The lender considers how risky the asset is. The lender gauges the risk factor based on factors like the liquidity and volatility of the asset. The lender also considers the prevailing sentiment and market condition. If the asset carries more risk, the asset will have a higher haircut value. Conversely, if the asset classifies as a less risky asset, it will have a lower haircut.

For instance, riskier assets like stocks may have a 50% haircut value. At the same time, bonds that are potentially less risky than stocks may have a haircut of 30%. This is because stock prices are volatile compared to bonds. The value of a stock could plummet by 20% or even more if the market perception changes towards that stock. However, there is no default risk, and bonds guarantee regular interest payments. The only variable with bonds is the rate of interest.

There are good times in the market where financial assets like stocks seem very lucrative investments. During these times, stocks tend to be relatively less volatile. Many inventors enter the market to invest and trade, which helps maintain high liquidity. On the flip side, when uncertainty and fear persist in the market, many investors tend to stay away from those same stocks and prefer investing in assets like bonds. During these times, the stocks are very volatile. So if the market conditions and sentiments are positive, the haircut of a particular stock may be relatively less than what it would be during uncertain times.

Features of a Haircut in the Stock Market

So, to summarise, the features of a haircut in the stock market are as follows:

  • The lender determines the haircut based on the risk associated with the asset.
  • Assets with high volatility have a high haircut. Assets with low liquidity also have a high haircut.
  • The haircut value will change with the changing market conditions.
  • The haircut functions to protect the lender from incurring a potential loss.

Due to these reasons, certainly, the lender will not offer an investor credit for the entire value of their pledged assets. In other words, the lender will value the assets for collateral purposes less than their market value. This is because in case the value of the assets falls, the lender would desire some buffer to absorb the loss. Therefore, the assets get placed as a collateral value less than the actual market value of the assets. In this way, a haircut protects the lender, who in most cases is the stockbroker or banker.

What is Pledging?

When lenders like banks give out loans, they require the money, who is the person asking for a loan, to pledge some of their assets as collateral. It simply means that the lender will have those assets until the loanee repays the loan to the lender. If the loanee defaults on the loan, the bank or the lender can have the assets on the loanee. In terms of the stock market, when an investor pledges their shares, it simply means they offer their shares as collateral for a loan.

What is the difference between haircut and repo rate?

A haircut is a percentage reduction in the value of a collateral asset. When a borrower offers an asset as collateral, the lender assess the risk associated with that asset and may apply a haircut. Lenders apply haircuts to protect from potential losses if the collateral needs to be sold if the borrower defaults. Additionally, an asset with a higher perceived risk will have a higher haircut.

The repo rate is the interest rate at which central banks lend money to commercial banks in exchange for government securities (usually bonds). A central bank uses it to manage inflation and control the money supply.

A higher repo rate makes borrowing money from the central bank more expensive and can affect other interest rates in the economy. Additionally, the repo rate is crucial in determining short-term interest rates in monetary policy.

Here is the key difference between Haircut and Repo Rate:

BasisHaircutRepo Rate
MeaningAmount of reduction in collateral’s valueThe interest rate at which central banks lend money against collateral
PurposeIn the event that the collateral value decreases, the lender is protected from potential losses.It manages inflation, controls the money supply, and determines short-term interest rates.
ApplicationLenders use this when accepting collateral for loans.Central banks set these for lending to financial institutions.
RiskReflects the perceived risk associated with the collateral.Reflects monetary policy objectives and economic conditions.
Impact on borrowingReduces the amount of funds that can be borrowed against collateralAffects the cost of borrowing for financial institutions and other interest rates

Conclusion

Through this article, we hope you now understand the meaning of a haircut in the share market and what a haircut in the share market means. Hence as a responsible investor, you should check the haircut before you decide to pledge your shares. Purchasing shares using loans itself is a very risky action. One will have more money to invest and can increase the potential return on their investment. But, investments in a way assure returns, so only the most experienced investors and traders should opt for pledging their shares at their own risk.