Haircuts and Collateral Management

Lend cash against a bond and you're exposed to one specific risk: the borrower defaults right when the bond's price has fallen, leaving you with collateral worth less than what you're owed. A haircut is the lender's answer — don't lend the full market value of the bond, lend a bit less, so there's a buffer to absorb a price move before the lender takes a loss.

How the number is set

The size of the haircut tracks how risky and how liquid the collateral is. A short-dated Treasury bill barely moves in price and can be sold instantly, so haircuts there might be under 1%. A long-dated Treasury bond is more volatile and gets a slightly larger haircut. Move down the credit ladder — corporate bonds, equities, securitized products — and haircuts climb quickly, because both price volatility and the risk of a slow, disorderly sale go up together.

$$\text{Loan amount} = \text{Collateral value} \times (1 - h)$$

In words: the cash you can borrow equals the market value of what you're posting, reduced by the haircut percentage $h$. Equivalently, the borrower must post more collateral than cash borrowed — the ratio of collateral value to loan is $1/(1-h)$.

Worked example

A dealer posts $20 million face value of a 10-year Treasury note, currently priced at 99.50, as collateral for a repo loan. Market value of the collateral: $20{,}000{,}000 \times 0.9950 = 19{,}900{,}000$. With a 2% haircut, the lender advances:

$$19{,}900{,}000 \times (1 - 0.02) = 19{,}502{,}000$$

So the dealer receives $19,502,000 in cash and must return it plus interest, while the lender holds collateral worth roughly $398,000 more than the loan — the cushion. If bond prices fall overnight and the collateral's value drops by less than 2%, the lender is still fully covered even if the dealer defaults before repayment.

What this means in practice

Haircuts move with stress. In calm markets, Treasury haircuts can be near zero; in a crisis, lenders raise haircuts sharply or refuse certain collateral outright, forcing borrowers to post more securities for the same cash — or to sell assets to raise cash directly. That dynamic, haircuts rising exactly when borrowers most need financing, is a core mechanism behind repo-market runs.