A repurchase agreement or repo is the sale of a security with a simultaneous agreement by the seller to buy the same security back from the buyer at an agreed-on price. When a repurchase agreement is viewed by a cash lending party, it is a reverse repurchase agreement.
Repo Margin and its Factors
Each market participant in a repurchase agreement is exposed to counterparty defaults, regardless of the collaterals. The agreement is structured as the lender of funds is the most vulnerable party. Repo margin (haircut in the US) is the difference between the market value of the security used as collateral and the value of the loan.
The level of margin is dependent on the following factors:
- The length of the repurchase agreement: The longer the repurchase agreement, the higher the repo margin.
- The quality of the collateral: The higher the quality, the lower the repo margin.
- The credit quality of the counterparty: The higher the creditworthiness, the lower the repo margin.
- The supply and demand for collateral: Repo margins are lower if the collateral is in high demand.
Which of the following factors lower the level of the repo margin?
I. A longer repurchase agreement
II. A higher quality of the collateral
III. A lower creditworthiness
A. I & III only
B. II only
C. All of the above.
The correct answer is B.
The quality of the collateral is one of the determinants of the repo margin. The higher the quality of the collateral, the lower the level of the repo margin.
Reading 51 LOS 51j:
Describe repurchase agreements (repos) and the risks associated with them