DISCLAIMER: Some haircuts are painful! And most definitely, it does not make you feel good!

Haircut, contrary to the popular definition, is also a financial term meaning the reduction in one’s assets. To be more precise, it is the percentage by which an asset’s market value is reduced for calculating requirements, margin and collateral levels. This term arises from the fact that borrowers, sometimes, are incapable of paying back the full debt.

Haircuts have been used for almost 200 years in commercial finance.

The concept of a haircut comes straight from the fact that borrower is incompetent to pay back the original amount and thus, the investor/lender has no option other than to receive an amount less than pre-decided.

The term would be more clear with an example, suppose you have to lend 10,000 Rs to a borrower and the Borrower, for some reason, cannot pay it back fully but has agreed to pay back 6000 Rs. This means that you’ll take a Rs 4000 haircut!

How is it feasible?

It is, because anything is definitely better than nothing! Since, you know already that you will never be repaid 100% of the debt. So, 6000 is obviously better than a 0 bank balance. Thus the new goal shifts to making advantage of the situation by getting the borrower to pay as much as possible!

But this haircut situation doesn’t guarantee that you will always want to settle for less. The lender has an option to cut the interest rate or push the repayment date way out into future.

The amount of the haircut reflects the lender’s perceived risks of loss from falling value of the owned asset.

Two styles

In financial markets, the term haircut is mainly used in two ways.

The first, explained above, provides the lenders and borrowers a one-off adjustment by reducing the amount (and not being unpaid) to suit both in a period of financial pain.

The second is the difference between the buying and selling price of a share, bond or other financial statement.

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