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Difference Between Haircut and Margin


A haircut (specifically, a collateral haircut) is the reduction to, or deduction from, the collateral posted by the borrower and held by the lender, in a repo transaction, in order to guarantee contractual fulfillment. In other words, it is the amount by which the sum borrowed against the collateral is less than the market value. This difference or discount helps protect the lender against changes in the market value of the collateral. For example, a trader may put up collateral worth 102% of the funds borrowed. The 2% is said to be the haircut of the repo transaction. Of course, the haircut relates to how much the collateral changes value in the market.

A haircut is an adjustment to the market value of collateral to account for the risk that the cash that may be realized by the liquidation of collateral, if so happens, would be less than the quoted market value of the securities posted, due to a host of market related developments such as issuer credit risks and market liquidity risks associated with the securities, as well as the operational and legal risks typically inherent in all types of collateral.

The formula of a haircut is:

Haircut = [(market value of collateral – loaned cash)/ market value of collateral] × 100

or,

Haircut = [(market value of collateral) × (1- deduction%)/ market value of collateral] × 100

A haircut is expressed as the percentage deduction from the market value of collateral (e.g., 2%).

On the other hand, margin (also called initial margin) is s a percentage premium added to the market value of the collateral (the securities posted in a repo or securities lending transaction). An initial margin on a repo or securities lending transaction is  calculated as follows:

Initial margin = (market value of collateral/ cash or market value of loan security) × 100

An initial margin is used to determine the market value of the securities required as collateral. It is calculated by dividing the collateral market value by the cash or market value of the security to be loaned (for example, an initial margin of 102 % implies that every 100 currency unit in cash can be borrowed through a repo, or a security worth 100 currency unit can be borrowed through a securities lending transaction by posting collateral of 100 × 102 % = 102).

Therefore, initial margins are expressed in relation to a base of 100%, with the addition of a premium, while haircuts are taken out of a base of 100% as a reduction.

In both cases, the additional premium and the amount of reduction generally serve as an overcollateralization technique in the hands of a lender. However, this may not always hold in the case of a haircut (as negative haircuts may form in case the amount of borrowed cash exceeds the market value of collateral- due to a drop in the market value for multiple reasons including an increase in the default risk of a borrower).



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