A repurchase agreement (or simply “repo”) is the sale of a security with a simultaneous agreement by the seller to buy back the same security from the same buyer at an agreed-upon price. When a repurchase agreement is viewed from the perspective of the cash lending party, it is commonly called a reverse repurchase agreement.
Each market participant in a repurchase agreement is exposed to counterparty defaults, regardless of the collaterals posted. The agreement is such that the lender of funds is always the most vulnerable party. As such, the repo margin (called haircut in the US) is the difference between the market value of the security used as collateral and the value of the loan.
Factors Affecting the Repo Margin
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 lowers the level of the repo margin?
A. A longer repurchase agreement
B. A higher quality of the collateral
C. A lower creditworthiness of the borrower
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 43 LOS 43j:
Describe repurchase agreements (repos) and the risks associated with them