In finance a haircut is the percentage of an asset used as collateral that is deducted from its market value. The Loan to Value and haircut should add up to 100%.
The haircut of an asset is a reflection on its risk. A general rule of thumb is that the lower the haircut is the safer the loan is, and the higher the haircut is the riskier the loan is.
A lower haircut also allows for more leverage and plays an important role in trading.
For example, high risk securities (such as stocks) can have a haircut as high as 30%, whereas the haircut of lower risk securities (such United States Treasury bills) are generally lower (around 10%).
This means that a $10,000 Treasury Bill can be used as collateral for a $9,000 loan, while a stock option worth the same amount ($10,000) can be used as collateral for a $7,000 loan.
In the context of exchange traded products then the term can be used interchangeably with “margin”.
The term is believed to have been coined because it allows market makers to trade at a thin spread.
More recently, especially since the 2008 global financial crisis, the term ‘to take a haircut’ can also mean to accept or receive less than what you are owed. For example “He was owed $100,000 but only managed to get $50,000. He took a 50% haircut.”
Video – What is a haircut?
This video explains the term’s meaning when referring to creditors getting back much less than they are owed.