Haircut refers to the percentage reduction applied to the value of an asset when it is used as collateral in financial transactions, such as loans, margin trading, or repurchase agreements (repos). This reduction acts as a safety cushion for lenders or counterparties against potential losses due to market fluctuations or credit risk.

In simple terms, a haircut represents the difference between the market value of an asset and the amount that can be borrowed against it. For example, if an investor pledges shares worth ?1,00,000 as collateral and the lender applies a 20% haircut, the investor can borrow only ?80,000.

Formula:

Haircut (%) = [(Market Value ñ Loan Value) / Market Value] ? 100

Example: If a bond worth ?10 lakh is accepted as collateral with a 10% haircut, the borrower will receive ?9 lakh in funds. The remaining ?1 lakh acts as a buffer for the lender in case the bondís value declines.

Purpose of a Haircut:

• Risk Management: It protects lenders from market volatility and ensures that the collateral retains sufficient value even during adverse price movements.
• Credit Protection: Haircuts reduce exposure to borrower default by maintaining an adequate margin of safety.
• Market Stability: Regulators and clearing corporations use haircuts to maintain financial discipline and reduce systemic risk.

Factors Influencing Haircuts:

• Asset type (equity, bond, government security, etc.)
• Price volatility of the asset
• Credit rating and liquidity
• Market conditions and counterparty risk

In the Indian context, organizations like the Reserve Bank of India (RBI) and clearing corporations determine standard haircut rates for different types of securities to ensure uniformity and transparency in financial markets.

In conclusion, a haircut is a crucial financial safeguard that balances risk between borrowers and lenders. By accounting for potential declines in collateral value, it ensures the stability and security of lending and trading systems across capital markets.