Repo Haircuts and Economic Capital: A Theory of Repo Pricing

TL;DR

This paper develops a theoretical model linking repo haircuts, spreads, and economic capital, explaining observed market behaviors and differences during financial crises.

Contribution

It introduces a novel repo haircut model that ties haircuts to credit criteria and economic capital, providing a unified explanation for repo pricing measures.

Findings

Repo haircut hikes during financial crises are empirically reproduced.

The model explains differences between tri-party and bilateral repo haircuts.

Shortening tenor reduces risk and impacts repo spreads.

Abstract

A repurchase agreement lets investors borrow cash to buy securities. Financier only lends to securities' market value after a haircut and charges interest. Repo pricing is characterized with its puzzling dual pricing measures: repo haircut and repo spread. This article develops a repo haircut model by designing haircuts to achieve high credit criteria, and identifies economic capital for repo's default risk as the main driver of repo pricing. A simple repo spread formula is obtained that relates spread to haircuts negative linearly. An investor wishing to minimize all-in funding cost can settle at an optimal combination of haircut and repo rate. The model empirically reproduces repo haircut hikes concerning asset backed securities during the financial crisis. It explains tri-party and bilateral repo haircut differences, quantifies shortening tenor's risk reduction effect, and sets a limit on excess liquidity intermediating dealers can extract between money market funds and hedge funds.