How Repo Collateral Value Changes Credit Exposure
Summary
The document explains credit exposure in a collateralized repo from the perspective of a bank that borrows cash from a hedge fund and posts bonds. The lender’s exposure is the cash advanced minus the market value of the collateral. If the posted bonds rise in value while the cash obligation is unchanged, the lender has more collateral available to recover the loan if the bank defaults, reducing the net exposure.
It also distinguishes this collateral effect from a bond trading special in the repo market. A specific bond in strong borrowing demand may command a lower repo rate than general collateral, often because short sellers need to borrow it for delivery. The explanation is qualitative and uses a simplified balance between cash and collateral; it does not discuss haircuts, margin calls, liquidation costs, valuation timing, or how exposure may change during a default closeout.
Key ideas
- Repo is a collateralized borrowing in which bonds secure a cash obligation.
- The lender’s simplified net exposure is cash lent minus the market value of bonds posted.
- A rise in the collateral bond’s value improves recovery in default and reduces exposure, all else equal.
- A bond in strong demand to borrow may trade special at a lower repo rate than general collateral.
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Full text
# Bond price and credit exposure in Repo agreement # Bond price and credit exposure in Repo agreement The answer is A. Could someone explain to me the reason that higher bond price reduces the credit exposure to the bank? Why is B incorrect? ## Answer by dm63 (score 2, accepted) https://quant.stackexchange.com/a/51618 A: The hedge fund is being lent bonds as collateral for the cash they are giving out. So, the net exposure to the bank is (cash out minus value of bonds being posted). Hence the answer. B: incorrect. A security trading ‘special’ in repo will have a lower repo rate than a general security. This is because if you want to borrow a particular bond, and that bond is in strong demand for borrowing , then the market will penalize the investment rate you are getting in your cash collateral. Why would a bond be in strong demand for borrowing? Usually because investors have sold the bond short, so they need to borrow it to satisfy delivery. ## Answer by Ali (score 0) https://quant.stackexchange.com/a/51619 Essentially, the repo is a collateralised borrowing. The bank is borrowing cash from the HF, and in return the bank is providing the HF with bonds worth USD100. Since the bond is a debt security and has a market value, assume that this particular bond becomes more valuable in the market and the price of this particular bond >USD100. As such, the collateral you provided to the HF is more valuable, and if the bank is unable to pay back the loan, the HF can sell the collateral bonds in the market for >USD100. Accordingly, the credit exposure of the bank is reduced if the market value of the posted bonds increases.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.