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Repo Haircuts and Economic Capital

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  • Wujiang Lou

Abstract

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.

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  • Wujiang Lou, 2016. "Repo Haircuts and Economic Capital," Papers 1604.05404, arXiv.org, revised Oct 2016.
  • Handle: RePEc:arx:papers:1604.05404
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    References listed on IDEAS

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    1. Cyrus Ramezani & Yong Zeng, 2007. "Maximum likelihood estimation of the double exponential jump-diffusion process," Annals of Finance, Springer, vol. 3(4), pages 487-507, October.
    2. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
    3. Duffie, Darrell, 2011. "Measuring Corporate Default Risk," OUP Catalogue, Oxford University Press, number 9780199279234.
    4. Adam Copeland & Antoine Martin & Michael Walker, 2014. "Repo Runs: Evidence from the Tri-Party Repo Market," Journal of Finance, American Finance Association, vol. 69(6), pages 2343-2380, December.
    5. Ning Cai & S. G. Kou, 2011. "Option Pricing Under a Mixed-Exponential Jump Diffusion Model," Management Science, INFORMS, vol. 57(11), pages 2067-2081, November.
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