A haircut is equivalent to the value of the collateral less the amount borrowed. The $25 difference is the one referred to as the haircut. The lender aims to ensure that the loan amount is less than the collateral. From the lender’s perspective, the haircut is the extent to which collateral value can fall and still be fully collateralized.
Things to Remember
- Collateral: Assets provided by a borrower to secure a loan or credit. In case of default, the lender can seize the collateral to recover the loan amount.
- Loan-to-Value Ratio: The ratio of the loan amount to the value of the collateral. A lower ratio indicates a lower risk for the lender.
- Margin Call: A demand by a lender for an investor to deposit additional money or securities to cover potential losses in case the value of the collateral falls below a certain level.
- Securities Lending: The practice of loaning securities to earn additional income. Haircuts are often applied in securities lending transactions to protect the lender.
