 This article develops a  haircut model by treating repos as debt investments and seeks haircuts to control counterparty contingent exposure to asset price gap risk. It corroborates well with empirically stylized facts, explains tri-party and bilateral repo haircut differences, recasts haircut increases during the financial crisis , and sets a limit on access liquidity dealers can extract while acting as funding intermediaries between money market funds and hedge funds . Once a haircut is set, repo's residual risk becomes a pricing challenge, as is neither hedgeable nor diversifiable. We propose a capital pricing approach of computing repo economic capital and charging the borrower a cost of capital. Capital charge is shown to be countercyclical and a key element of repo pricing and used in explaining the repo pricing puzzle and maturity compression phenomenon .
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 .
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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.
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repo
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treating repos as debt investments and seeks haircuts to control counterparty contingent exposure to asset price gap risk. It corroborates well with empirically stylized facts,
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
R
recasts haircut increases during the financial crisis
quantifies shortening tenor's risk reduction effect
R
access liquidity
excess liquidity intermediating
D
while acting as funding intermediaries
D
. Once a haircut is set, repo's residual risk becomes a pricing challenge, as is neither hedgeable nor diversifiable. We propose a capital pricing approach of computing repo economic capital and charging the borrower a cost of capital. Capital charge is shown to be countercyclical and a key element of repo pricing and used in explaining the repo pricing puzzle and maturity compression phenomenon