Repo Collateral Choice, Haircuts, and Substitution Risk

Summary

The question concerns a lender’s exposure when a repo borrower can choose among eligible collateral. The borrower generally retains the collateral’s performance while the loan is outstanding, and weak collateral performance can trigger a demand for additional collateral. Eligible assets may have different haircuts, so the amount borrowed against each asset reflects its risk; the agreement may also specify different rates or terms for different collateral choices.

The answer implies that collateral substitution is governed by the contract’s eligibility schedule and the counterparties’ credit and transaction details. It does not offer a hedge for the lender’s risk that the borrower selects collateral with a less favorable return. The discussion is brief and gives no quantitative model or hedge design, so it serves as a general explanation of repo collateral terms rather than a complete risk-management method.

Key ideas

• Repo agreements can allow borrowers to choose among eligible collateral securities.
• Collateral performance generally belongs to the borrower until default, while poor performance may require additional collateral.
• Haircuts usually vary with collateral risk and affect borrowing capacity.
• Eligibility, haircuts, and rates depend on contractual terms and the parties and transaction involved.

Tags

# does anyone calculate substitution risk?


# does anyone calculate substitution risk?












So a company can post collateral to borrow money (repo agreement) and they may have different options of collateral to post. I have to pay a return on their collateral while I hold it. Since, at the end of the day a human has to post that, they might not post collateral that gets the best return. If they do an audit or something and find that they can sub a bunch of stuff for a better return, I'll end up having to pay more.

Is there any way I can hedge that risk?

## Answer by Charles Fox (score 1)

https://quant.stackexchange.com/a/45159

In general:

Until the borrower defaults, the performance of the collateral belongs to the borrower. If the collateral performs poorly, they can be asked to post additional collateral. Higher risk collateral usually requires a larger haircut. For example, if I want to post treasury bonds as collateral, I will likely be able to borrow \$99 for every \$100 of treasury bonds I post as collateral. If I want to use stocks, I might only be able to borrow \$30 per $100 of stocks posted. If the agreement gives me the flexibility to post different securities as collateral, it will likely come with a schedule of what is eligible how large the haircut will be and the interest rate depending on what I pick.

The agreements also depend on the credit quality of the two parties, what is being purchased with the borrowed money, etc.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.