Journal of Credit Risk

Risk.net

Repo haircuts and economic capital: a theory of repo pricing

Wujiang Lou

  • A transaction repo pricing model is developed that determines haircuts to control lenders’ exposure to collateral price gap risk during the margin period of risk, so that a preset credit criteria is satisfied.
  • Given a haircut, the repo spread is primarily driven by the cost of economic capital associated with the unhedgeable gap risk.
  • Repos’ dual pricing measures of haircuts and spreads are linearly related because EC is negatively linear in haircuts. An investor wishing to minimize all-in funding cost can settle at an optimal combination of haircut and repo rate.
  • The model could be used for pricing, risk and capital management of longer term, OTC repos on lower quality collateral. It could also aid, from a micro perspective, econometric studies of repo haircuts, repo spreads and their determinants.

Repo pricing is characterized by its puzzling dual pricing measures: the repo haircut and the repo spread. This paper develops a repo haircut model by designing haircuts to satisfy preset credit criterions and identifies economic capital for repo default risk as the main driver of repo spreads. A simple linear formula is obtained that relates repo spreads to haircuts. An investor wishing to minimize their all-in funding cost can settle at an optimal combination of the haircut and repo rate. The model corroborates stylized facts, such as triparty repo haircuts’ insensitivity to counterparties, the differences between triparty and bilateral haircuts, and the lenders’ shortening repo tenor when market stress is developing.

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