What is Haircut in the Stock Markets?

Last Updated: 6 Jul 2022

If you are a trader in the stock market, you must be familiar with the term haircut. What is a haircut in the stock market and what is haircut value? Let us first look at what a haircut in the share market means. A haircut comes into play since the financier or exchange cannot give you credit for the entire value of the stock. They will give you credit after the haircut in the share market. But how is this haircut value decided? We will come back to what is a haircut in the stock market later.

When an exchange or lender considers the value of assets as collateral of the loan, they take a lower value. The lower value is the haircut value. For example, equity might have a 50% haircut but gold may have only 10% haircut value and debt may also have just 20% haircut value. Haircut in the stock market is all about the type of asset that you present as collateral.

Haircut in the Stock Markets

Let us first look at what is a haircut in the stock market? You must remember that when the collateral is being pledged, the haircut value will be decided by the amount of associated risk to the lender. As we mentioned earlier, the greater the risk, the greater will be the haircut value, and vice versa.

Haircut in the stock market is meant to protect the interest of the lender in the event of a price fall. For example, if you pledge shares worth Rs.10 lakhs, and if the lender gives you Rs.9.50 lakhs and tomorrow if the stock falls by 20%, the lender is at a huge loss. Haircut in the share market is meant to cover such risks. These risks include variables that may impact the value of the collateral if the concerned lender has to sell the security in the event of a loan default by the borrower. Haircut in the stock market or haircut in the share market is influenced by price, volatility, credit quality and asset liquidity, and secondary market value.

Here are some key features of a haircut in the stock market that you must be familiar with.

• Haircut value is the cut below the market value that is placed as safe value to accept the asset as collateral for the loan.
• The size of haircut value is predicated on the risk or nature of assets. Normally, equities are high risk so have high haircuts and gold has low haircuts. If the asset is riskier, automatically the haircut value will be higher.
• Haircuts keep changing and they depend on the change like assets. For example, if frontline stocks become too volatile, the bank or lender may increase the haircut on such stocks unilaterally to protect the lender interest.

Haircuts in stock markets and haircuts in share markets are the highest because the risk perception is the highest as compared to other asset classes. If you take the case of government bonds, there is no default risk, redemption is guaranteed and interest is also guaranteed. The only risk is interest rate risk so the collateral value will be high and the haircut will be below. That is not the case with equities that tend to be very volatile and hence haircuts will be very high in comparison.

To sum it up, any asset or security that is characterized by higher volatility and price uncertainty will automatically have larger haircuts when they are used as collateral. In the Indian context and the global context, the haircut for equities is mostly 50%. That means if you pledge shares worth Rs.25 lakhs, you get a collateral value of Rs.12.50 lakhs for the loan. That is why, most of the highly volatile stocks and penny stocks are either not accepted as collateral or even if they are accepted, the haircuts are a dissuading factor.

What is pledging

Pledging is creating a pledge or lien on an asset. When banks give loans, they insist that an asset be pledged along with the loan as security. You give the bank or lender a lien on the asset meaning that if you default on the interest or the EMI or the principal, the lender is at liberty to dispose of your asset to recover dues. This applies to all assets including equities, mutual funds, bonds, property, etc.

The person who pledges the asset and takes the loan is the pledger. The lender who takes the assets as a pledge is the pledgee.

What is a loan against shares?

One of the ways of monetizing your equity Demat holdings is to borrow against shares. Here again, you can borrow with a haircut of around 40-50% as the case and risk perception may be. You can raise liquidity by a loan against shares without selling your shares by just hypothecating the shares with the lenders. If your broker has an NBFC or bank affiliation, they can directly pledge from your DP account itself. LAS can be disbursed in a few hours.

Frequently Asked Questions

What is a risk based haircut?

Risk based haircut is the practice of determining haircut based on risk of asset and volatility. Higher the risk and volatility associated, higher the haircut for the purpose of loan collateral. Equity has a high haircut of 40-50% in general.

Who determines the haircut value?

Haircut value is broadly defined by the exchange in the case of equities and banks have their own internal practices also for determining haircut value.

What is a spread?

Spread is another definition of haircut. It is the spread between the bid price and ask price that the market maker or the jobber earns when making markets in various assets.