What Is a Haircut in Finance? Meaning and Examples

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A haircut in finance is the percentage reduction applied to an asset’s market value when that asset is used as collateral, so a lender counts it as worth less than its current price. If a bond portfolio worth $1 million carries a 10% haircut, the lender treats it as $900,000 of collateral. The gap is a cushion: if the borrower defaults and the asset has to be sold, the lender has room for the price to fall before the loan is no longer covered.

The word has two looser meanings: the loss creditors accept in a debt restructuring, and the small amount a trader gives up through the bid-ask spread when buying and selling immediately.

How a Haircut Works

Collateral is an asset a borrower pledges so the lender can sell it if the loan is not repaid. The haircut sets how far below today’s price the lender values that asset to stay protected while it waits to sell.

Haircuts show up most in lending between financial institutions. In a repurchase agreement (repo), one party sells securities to another for cash and agrees to buy them back later, often the next day, at a slightly higher price. Economically this is a secured loan, and the cash lender applies a haircut to the securities it receives. Haircuts also apply when a brokerage customer borrows on margin against a stock portfolio, when a central bank lends against eligible collateral, and when a business borrows against inventory or receivables.

The haircut formula

The basic relationships are:

• Haircut (%) = (Market value − Collateral value) ÷ Market value
• Maximum loan = Market value × (1 − Haircut)
• Collateral required = Loan amount ÷ (1 − Haircut)

The third formula catches people out. A 5% haircut does not mean posting 5% extra collateral. To borrow $1,000,000 with a 5% haircut, the borrower needs $1,000,000 ÷ 0.95 = about $1,052,632 of securities, not $1,050,000.

Some markets quote the same protection as a margin ratio: collateral value divided by loan amount. A 5% haircut corresponds to a margin ratio of about 105.26%. Both describe the same buffer, but the numbers are not interchangeable, so it matters which convention a contract uses.

A 100% haircut means the asset has zero collateral value: a broker that lists a stock this way will not let it support any borrowing, though the shares can still be held and sold.

What determines the size of a haircut

No single formula applies across lenders. Each sets its own schedule, but the same factors drive it:

• Volatility. The more an asset’s price can move during the time it would take to sell, the larger the haircut. Short-dated government bills usually sit at the low end; equities sit higher.
• Liquidity. An asset that is hard to sell quickly may have to be dumped at a discount, so illiquid collateral gets a bigger cut.
• Credit and price risk. A corporate bond can lose value permanently through default, so it typically receives a larger haircut than a comparable government bond.
• Borrower risk. A borrower more likely to default raises the chance the lender actually has to sell, which can justify a larger haircut.
• Maturity and currency mismatch. Longer-dated bonds move more with interest rates, and collateral denominated in a different currency from the loan adds exchange-rate risk.

Regulators also impose haircuts. Bank capital rules under the Basel framework include supervisory haircuts that reduce how much credit protection a bank can recognize from collateral. In the U.S., the SEC’s net capital rule (Rule 15c3-1) requires broker-dealers to deduct haircuts from the value of securities they hold when calculating their capital.

Examples of a Haircut in Finance

Repo loan (hypothetical). A bank pledges $20 million of government bonds in an overnight repo with a 2% haircut. It receives $20,000,000 × 0.98 = $19.6 million in cash. If the bank fails to repurchase the bonds, the lender can sell them and still be covered unless their price falls more than 2% before the sale.

Margin account (hypothetical). An investor holds $50,000 of a stock that the broker values with a 30% haircut. The account can support up to $35,000 of borrowing against that position. If the stock drops to $40,000, its collateral value falls to $28,000. A loan already above that level would trigger a margin call, forcing the investor to add cash or sell. Different brokers can apply different haircuts to the same stock, so borrowing capacity depends on the firm.

Inventory financing (hypothetical). A retailer borrows against $2 million of warehouse stock. The lender advances 60% of the appraised value, an effective 40% haircut, and lends $1.2 million. Inventory gets larger haircuts than bonds because it may spoil, go out of style or sell only at liquidation prices, and the lender must pay to seize and sell physical goods.

Market maker spread. A stock shows a last price of $50, with a bid of $49.98 and an ask of $50.02. Selling 100 shares at market fills at the bid for $4,998 before fees. Buying them straight back at the ask costs $5,002. The $4 difference is the “haircut” collected by the market maker, which earns the spread by quoting both sides.

Haircuts on Debt: “Taking a Haircut”

When a borrower cannot pay in full, creditors may accept a reduced claim. A bondholder who exchanges $1,000 of face value for new bonds worth $600 has taken a 40% haircut. This happens in corporate bankruptcies and sovereign debt crises; in Greece’s 2012 restructuring, private bondholders accepted a reduction of more than half the face value of their bonds. Here the haircut is a realized loss rather than a safety buffer, but the arithmetic is the same.

Why Haircuts Matter: The LTCM Case

Long-Term Capital Management, a hedge fund founded in 1994, ran arbitrage strategies with thin profits per trade, so it borrowed heavily: roughly $30 of debt for every $1 of capital, alongside more than $1 trillion in notional derivatives exposure. Its lenders required little or no haircut on its repo borrowing, which left them without a buffer. When markets turned in 1998 and default became a real risk, so much collateral would have been sold at once into falling markets that the Federal Reserve Bank of New York organized a group of 14 banks and brokerages to put in $3.6 billion to recapitalize the fund. Thin haircuts had let leverage build across the system, a weakness that remained in place into the 2008 financial crisis.

Limitations of Haircuts

• They are based on past behavior. A haircut sized to normal volatility can be too small in a sharp sell-off, when prices gap and buyers disappear.
• They can amplify stress. Lenders tend to raise haircuts when markets become turbulent. Higher haircuts cut borrowers’ funding at the moment assets are hardest to sell, which can force more selling and push prices lower.
• They do not cover everything. A haircut protects against a fall in collateral value, not against legal delays, operational failures or a counterparty that cannot return collateral.
• They make funding costlier. Every dollar of haircut is capital the borrower must supply itself, which lowers the leverage available and can reduce returns on a trading strategy.

Haircut vs. Related Terms

• Haircut vs. loan-to-value (LTV). LTV is the loan divided by the asset’s value. A loan made at the maximum allowed under a 20% haircut has an 80% LTV. The two measures describe the same cushion from opposite sides.
• Haircut vs. margin. In securities lending and repo, “margin” can mean the margin ratio above, while in a brokerage account it means the investor’s own equity. A haircut is the lender’s discount to the asset, regardless of how the account is labeled.
• Haircut vs. write-down. A write-down reduces an asset’s value on a company’s books. A collateral haircut changes nothing on the owner’s balance sheet; the asset stays at market value and only its borrowing power is reduced.

The Bottom Line

Haircuts matter to anyone who borrows against securities, inventory or receivables, from margin investors to banks in the repo market. The size of the haircut sets how much cash an asset can raise and how much capital the borrower must supply itself. The LTCM collapse showed that thin haircuts let leverage build, so borrowers should expect haircuts to vary by lender and to rise when markets come under stress.