The US Financial System and its Crises by Giorgio Pizzutto
Author:Giorgio Pizzutto
Language: eng
Format: epub
ISBN: 9783030144890
Publisher: Springer International Publishing
However, this market is not completely without risk because the value of the collateral may fluctuate. The risk to the lender is borrower bankruptcy coupled with a drop in the value of the security given as collateral. The borrower also runs certain risks. The lender might fail and thus not return the asset. If the value of the asset given as collateral also increases, the loss to the borrower is only partially compensated by not having to repay the loan.
To mitigate the risk, the transaction is accompanied by a discount known as a “haircut,” which reflects the perceived risk associated with the asset used as collateral. The higher the haircut, the lower the reliability of the asset. For example, a haircut of 10% means that a borrower would have to turn over collateral worth one million dollars to obtain a loan of $900,000. Likewise, a 20% haircut means an 800,000-dollar loan would require collateral worth one million and the borrower has to chip in 200,000 dollars of its own funds if it wants to purchase assets worth one million.
Transactions of this type are also seen on other markets. One example is the real estate market, where the purchase of a house is financed in part with the buyer’s own funds and in part through a loan from a bank. If the margin is 10%, the ratio between the loan and the value of the purchased assets (loan to value) is 90%, whereas the collateral rate is 100/90 = 111%. Perhaps the best-known indicator for illustrating the amount covered by the loan and the borrower’s consequent level of indebtedness is leverage. Leverage is the reciprocal of margin. It is the ratio between the value of the asset and the borrower’s own capital necessary to purchase it. Own capital is thus the difference between the value of the financial asset or any other good that is purchased, and the amount borrowed.
The value of the loan thus tends to be less than the value of the collateral and the initial margin serves to protect the lender from a sudden reduction in the value of the collateral, an increase in its volatility and illiquidity, and the counterparty credit risk (the risk that the borrower in a collateralized loan is partially or wholly unable to repay).
The value of the margin and the collateral defined in the transaction is not fixed but may be changed to maintain the market value of the asset provided as collateral. If this value should decrease, the lender of money could make a margin call, asking the borrower to add collateral and thus implicitly increase the margin. An increase in margin means that the lender perceives a greater risk associated with its loan deriving from a possible reduction in value of the collateral and thus protects itself by increasing the margin. If the borrower is not able to meet the request, it risks losing the collateral. Indeed, the lender has the right to sell the temporarily held assets if the debtor is unable to meet a margin call.
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