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Contrast the transaction types found in collateral markets and account for the risks that these transactions can create.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Liquidity and Leverage · FRM2.LTR.2.c

The idea

Collateral markets let a party obtain cash or securities against collateral. In a repo, the seller delivers securities and receives cash equal to market value less a haircut. The seller agrees to repurchase later at a price that adds interest. In US convention, Interest = cash × rate × days ÷ 360. The counterparty is doing a reverse repo. Securities lending is driven by the borrower's need for a specific security, paid for by a fee, with cash or securities as collateral. A total return swap passes the asset's total return to the receiver in exchange for a financing payment, giving leveraged exposure off balance sheet. The risks are haircuts and margins that rise with volatility, refusal to roll, counterparty failure, losses on reinvested cash collateral, and rehypothecation chains that leave the collateral giver an unsecured creditor. For repo financing, the maximum leverage is Leverage = 1 ÷ haircut.

Formulas

Cash raised in a repo

Cash = MV × (1 − h)

MV
the market value of the securities delivered
h
the haircut, as a decimal

The lender advances less than market value. With equity funding only the haircut, maximum leverage is 1 ÷ h, so a higher haircut forces deleveraging.

Repurchase price of a repo

Repurchase price = Cash × (1 + r × days ÷ 360)

Cash
the cash lent, market value less the haircut
r
the annual repo rate
days
the term of the repo in days

US convention is actual/360. Interest is on the cash lent, not on the market value of the collateral.

A practice question

From the question bank, with the reason each wrong option is wrong.

In a repurchase agreement, which description of the party that receives cash and delivers securities is correct?

  1. It is the reverse repo party, which borrows cash against its securities and repays that cash later at a higher price.Why not: Mixes the labels: the cash lender takes the reverse repo side.
  2. It has sold the securities outright and has no obligation to buy them back.Why not: Ignores the repurchase commitment that makes the trade a secured loan.
  3. It is the repo seller, a cash borrower that repurchases the securities later at a higher price; the counterparty does a reverse repo. - correct
  4. It is a securities lender that receives a lending fee and never receives cash.Why not: Confuses repo with securities lending, where the fee is the return and the collateral can be securities.

A repo is a sale with a commitment to repurchase, economically a collateralised loan; the cash borrower is the repo seller and the cash lender is on a reverse repo.

A harder one

A pension fund lends government bonds and receives cash collateral, which its manager invests in one-year asset-backed securities. What is the principal risk this creates?

  1. Only the default risk of the borrower, because holding cash collateral removes every other risk to the lender.Why not: Treats cash collateral as risk-free for the lender, ignoring the risk in how the cash is reinvested.
  2. Reinvestment risk: the cash is returnable on demand but the reinvested assets may have lost value or turned illiquid. - correct
  3. Delivery risk, because the lender no longer owns the bonds and cannot recover them from the borrower on demand.Why not: Confuses lending with sale; the lender keeps ownership and can recall the securities.
  4. Interest rate risk on the lent bonds, which transfers entirely to the borrower during the loan.Why not: Wrongly assumes market risk of the lent bonds passes to the borrower; the lender keeps the economic exposure.

Return of cash on demand against a longer or riskier reinvestment portfolio is a liquidity and market risk mismatch; several lenders suffered losses of this kind in 2008.

The hardest tier

A hedge fund finances bonds with a market value of USD 100 million in a repo with a 10% haircut. The bonds then fall 6% in price and the lender raises the haircut to 15%. What cash must the fund deliver to restore the margin requirement, closest to?

  1. USD 5.4 millionWhy not: Applies the price fall but keeps the old 10% haircut, ignoring the increase to 15%.
  2. USD 6.0 millionWhy not: Takes the full mark-to-market loss as the call, ignoring that the loan is only 90% of the value.
  3. USD 10.1 million - correct
  4. USD 5.0 millionWhy not: Applies the higher haircut to the original value and ignores the price decline.

Initial loan = 0.90 x 100 = 90. New collateral value = 94; loan allowed = 0.85 x 94 = 79.9. Call = 90 - 79.9 = 10.1. Price fall and haircut increase compound.

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