A haircut is the difference between the initial market value of an asset and the purchase price paid for that asset at the start of a repo. An initial margin is analogous in function to a haircut. The difference between the two is merely a matter of expression. A haircut is expressed as the percentage deduction from the market value of collateral (eg 2%), while an initial margin is the initial market value of collateral expressed as a percentage of the purchase price (eg 105%) or as a simple ratio (eg 105:100).
Ideally, collateral should be free of credit and liquidity risks. The market value of such risk-free collateral would be more certain, meaning that it would be easy to sell for a more predictable value in the event of default by the collateral-giver. The type of asset that comes closest to this paradigm, and is in fact the most commonly-used type of collateral in the repo market, is a domestic bond issued by a creditworthy central government.
Assets that pose material credit and/or liquidity risks can be used as collateral but their value needs to be adjusted for their risk by deducting a haircut from the market value of collateral in order to calculate the purchase price or multiplying the purchase price by an initial margin in order to calculate the required collateral market value.
A haircut or initial margin represents the potential loss of value due to factors such as:
- price volatility between regular variation margining dates (in case there is a default between a calculation of a variation margin call and the payment or delivery of that variation margin;
- the probable cost of liquidating collateral following an event of default due to the impact of liquidation on market price*; and
- the possibility of the issuer of the collateral defaulting.
The use of haircuts and initial margins is explained in the guidance on efficient margining set out in the Guide to Best Practice in the European Repo Market published by the European Repo and Collateral Council (ERCC) of the ICMA.
* It is also possible that the non-defaulting party may have to buy securities that it had expected to receive from the defaulting party. In this case, its risk is that buying will drive up market price.
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