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Securities Lending Haircuts and Indemnification Pricing

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  • Wujiang Lou

Abstract

Securities borrowing and lending are critical to proper functioning of securities markets. To alleviate securities owners' exposure to borrower default risk, overcollateralization and indemnification are provided by the borrower and the lending agent respectively. Haircuts as the level of overcollateralization and the cost of indemnification are naturally interrelated: the higher haircut is, the lower cost shall become. This article presents a method of quantifying their relationship. Borrower dependent haircuts satisfying the lender's credit risk appetite are computed for US Treasuries and main equities by applying a repo haircut model to bilateral securities lending transactions. Indemnification is designed to fulfill a triple-A risk appetite when the transaction haircut fails to deliver. The cost of indemnification consists of a risk charge, a capital charge, and a funding charge, each corresponding to the expected loss, the economic capital, and the redundant fund needed to arrive at the triple-A haircut.

Suggested Citation

  • Wujiang Lou, 2021. "Securities Lending Haircuts and Indemnification Pricing," Papers 2111.13228, arXiv.org.
    • Handle: RePEc:arx:papers:2111.13228
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    References listed on IDEAS

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    1. S. G. Kou, 2002. "A Jump-Diffusion Model for Option Pricing," Management Science, INFORMS, vol. 48(8), pages 1086-1101, August.
    2. Wujiang Lou, 2016. "Repo Haircuts and Economic Capital: A Theory of Repo Pricing," Papers 1604.05404, arXiv.org, revised Jul 2020.
    3. Viktoria Baklanova & Cecilia Caglio & Frank Keane & Burt Porter, 2016. "A Pilot Survey of Agent Securities Lending Activity," Working Papers 16-08, Office of Financial Research, US Department of the Treasury.
    4. Duffie, Darrell & Garleanu, Nicolae & Pedersen, Lasse Heje, 2002. "Securities lending, shorting, and pricing," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 307-339.
    5. Nathan Foley-Fisher & Stefan Gissler & Stephane Verani, 2019. "Over-the-Counter Market Liquidity and Securities Lending," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 272-294, July.
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