Dear David,
I recall I've read somewhere before that haircut gives leverage. I'd like to just verify with you about a very simple example I've imagined, which involves the haircut and the resultant leverage.
A trader borrows cash with 10% haircut against a security that is valued at $100. Due to the haircut of 10%, the equity he posted is $100*10% = $10 as he can only borrow $90. If the value of the collateral goes down by 1% or $1, he will then need to post additional equity of $1 to make up the loss, which represents 10% of his initial equity. So this amplification of loss from 1% in the asset to 10% in the equity is a leverage of 10 for the trader.
Am I right to link this kind of scenario to the real leverage effect of haircut? Or do I have any misunderstanding about their relationship?
Thank you very much!
Liming
16/11/09
I recall I've read somewhere before that haircut gives leverage. I'd like to just verify with you about a very simple example I've imagined, which involves the haircut and the resultant leverage.
A trader borrows cash with 10% haircut against a security that is valued at $100. Due to the haircut of 10%, the equity he posted is $100*10% = $10 as he can only borrow $90. If the value of the collateral goes down by 1% or $1, he will then need to post additional equity of $1 to make up the loss, which represents 10% of his initial equity. So this amplification of loss from 1% in the asset to 10% in the equity is a leverage of 10 for the trader.
Am I right to link this kind of scenario to the real leverage effect of haircut? Or do I have any misunderstanding about their relationship?
Thank you very much!
Liming
16/11/09
