Lesson 4 of 20 · 6 min
What a haircut is, and why it exists
A haircut is the discount between market value and lending value, and it is a price for time.
A haircut is the other side of the advance rate. If the advance rate is 60 percent, the haircut is 40 percent. Same fact, stated from the direction of what was removed rather than what remains.
The reason a haircut exists is time. When a lender sells collateral, it does not receive today's price. It receives the price at some later moment, after the decision to sell, the notification, the order, and the fill. In a falling market those steps cost money. The haircut is the lender's estimate of how far the asset could move against it during the window in which it is trying to get out.
That estimate scales with two things: how much the asset moves, and how hard it is to sell in size. A short-term treasury fund barely moves and trades in enormous size, so its haircut is small. A single volatile stock can gap ten percent overnight and has a thinner order book, so its haircut is large. The haircut is not a judgment about quality. A fine company can carry a large haircut simply because its price is jumpy.
One consequence worth sitting with: because the haircut is a forecast of stress, it is most likely to be revised upward at exactly the moment your collateral is already falling. The discount and the drop tend to arrive together. That is not bad luck; it is the same cause producing both.
Key terms
- Haircut
- The percentage of market value a lender refuses to count as collateral. The complement of the advance rate: haircut = 100% − advance rate.
- Liquidation window
- The time between a lender deciding to sell collateral and the cash arriving. The haircut is priced to survive this window.
- Gap
- A price move that happens with no trading in between, typically overnight. Gaps are why a haircut cannot be small on a volatile asset.
Worked example
Reading a haircut as a survivable drop
A position worth $200,000 carries a 65% advance rate.
- Advance rate
- 65%
- Haircut
- 35%
- Lending value
- $130,000
- Price drop absorbed before lending value falls under the loan, at a $130,000 balance
- 0%
100% − 65%
$200,000 × 0.65
Borrowing the full lending value leaves no room at all.
A haircut is a cushion for the lender, not for you. Drawing the entire lending value hands the whole cushion back.
Check yourself
Two stocks each trade at $100. One moves about 15% a year, the other about 45%. Which carries the larger haircut, and why?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.