What is the purpose of haircuts in collateral valuation?

• A. Lower collateral value to reflect liquidity risk, market conditions, and forced-sale risk.
• B. Increase collateral value to secure larger loans.
• C. Adjust interest rates based on collateral type.
• D. Eliminate the need for appraisal.

Answer: (A)

Haircuts are a conservative adjustment to the reported value of collateral to protect the lender against risk. They account for the fact that an asset’s price can fall, may be difficult to sell quickly, and may incur costs if sold under stress. By reducing the usable collateral value, lenders create a cushion that helps ensure the loan remains adequately secured even in adverse conditions. The size of the haircut depends on how liquid and volatile the asset is and how market conditions might affect forced sales; illiquid or highly volatile assets get larger haircuts. For example, a pledged asset valued at 100 with a haircut of 20% yields a usable value of 80, tightening the loan’s collateral coverage. Haircuts are not used to boost collateral value, they do not directly set interest rates, and they don’t eliminate the need for appraisal—the valuation is adjusted downward by the haircut after an initial appraisal.