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Haircut

The discount applied to collateral's market value when calculating how much credit it supports, sized to cover potential price falls before the collateral could be sold.

Pledging $10 million of a security with a 5% haircut supports $9.5 million of borrowing. Government bonds attract haircuts of a percent or two; equities and lower-quality credit attract far more; illiquid or volatile assets may not be eligible at all.

Haircuts are procyclical, which is the core problem. They are low when volatility is low and rise sharply in stress, forcing borrowers to post more collateral or reduce positions exactly when prices are falling. That feedback loop amplified the deleveraging in 2008 and in March 2020.

For a leveraged strategy, the haircut schedule effectively sets maximum leverage, and its sensitivity to volatility sets how quickly that maximum can shrink. Stress the schedule, not just the prices. See collateral and margin-call.

Related: collateral, repurchase-agreement, margin-call, portfolio-margin, variation-margin, leverage

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Margin and leverageA small deposit controlling a much larger position, and the point at which losses trigger a margin call.Position you controlnotional value $100,000your margin deposit: $5,000$100,000 / $5,000 = 20:1 leverageYour deposit absorbs every dollar of loss$5,000$2,500$0Equity leftMARGIN CALLequity has fallen to $2,5000%1%2%2.5%3%4%5%How far the price moves against you
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
Payoff of a long call at expiryA flat loss equal to the premium below the strike, turning upward at 45 degrees above it.Profit / loss per share08595115125Strike 105Max loss 3 — the premium paidBreakeven 108Profit keeps growingUnderlying price at expiry
Buying a call: payoff at expiry. A 105-strike call bought for 3 loses that whole 3 if the price finishes at or below 105, breaks even at 108, then gains a dollar for every dollar higher. The loss is capped at the premium; the upside is not capped.

Educational only, not advice. Spotted an error? Post in Site Feedback.