Repo Haircuts, Collateral Direction, and Quoted Repo Rates
Summary
The document examines haircuts in bond repurchase agreements, framing a repo as an exchange of cash and bonds that is reversed at maturity. It asks why market practice generally uses overcollateralization, how that convention relates to the risks of the cash borrower and bond borrower, and whether the repo rate should reflect the amount of collateral posted.
The question distinguishes collateral protection from the economics of the transaction: the cash borrower may provide more bond value than the cash received, while the reverse leg returns collateral against repayment. It also suggests that a haircut could affect the fair terms of the repo, including its rate. No answer or market evidence is supplied, so the document does not resolve the reasons for conventional haircut direction, the treatment of a potentially undercollateralized arrangement, or how quoted rates account for collateral terms. Its example is presented as a question rather than a general account of market practice.
Key ideas
- A repo exchanges bond collateral for cash and reverses the exchange at maturity.
- A haircut means the posted collateral value exceeds the cash advanced.
- The document asks how collateral direction relates to which counterparty bears greater risk.
- It also asks whether repo rates reflect the haircut, but provides no answer or supporting evidence.
Tags
Full text
# bond repo - credit risk management with haircut # bond repo - credit risk management with haircut In a typical say 1 week bond repo deal , as i understand , typically X units of bonds are exchanged for P.X cash at spot date (P=dirty price of bond) , and in 1 week , X units of bonds are returned, and cash of P.(1 + repo*T).X is paid. BUT , sometimes , a haircut / "overcollateralisation" is done , and so actually at inception 1.05X units are exchanged for P.X cash , and at maturity 1.05Xunits are rturned for P.(1+repo*T).1.05X (like in Lehmans repo105 deal) What i dont understand here is a) why is it always that it's OVERcollateralisation thats done - and its never UNDercollateralisation? after all , in the repo deal , it can be thought of as an exchange of 2 loans, 1 party borrowing cash and posting bond collateral and the other party borrowing bonds and posting cash collateral, and which ever party is riskier should put up more collateral, so if the party that borrows bonds is riskier, then the deal should be UNDercollateralised - ie P.X cash should be exchanged for 0.95 X units of bonds. b) the repo rate must depend on the degree of overcollateralisation , ie on how off market the spot deal is , since for the whole repo deal to be fair , the forward deal must be sufficiently out of the-money to compensate for how much the spot deal is in the money. so , when repo rates are reported , why is the degree of collateralisation not indicated? perhaps the answer is that everyone knows the degree of collateralisation, and that it does not change much between dealers , and doesnt have much impact on the rate ?
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.