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FRM Part II · FRM Exam Part II

Repurchase Agreements and Financing for FRM Part II

A repurchase agreement (repo) is a secured loan: one party sells a security and agrees to buy it back later at a higher price. The price difference is the interest. To solve questions, identify who lends cash, compute the haircut and repo interest, then judge the collateral, counterparty and rollover risks.

What this chapter covers

This chapter covers repos as the main route for secured short-term funding. You learn how a repo works: a cash borrower sells a security, agrees to repurchase it at a set price and date, and pays the repo rate. You also learn how it is settled, how haircuts and margin protect the cash lender, and how dealers, funds and banks use repos to finance positions and obtain collateral.

The second half is about what goes wrong. Repos are short term, so they must be rolled over. When collateral values fall, haircuts rise or lenders lose confidence, funding can vanish quickly. That is a run. You then see how regulation and liquidity management try to limit this risk, including central clearing, minimum haircut ideas and liquidity buffers under Basel liquidity standards.

The chapter links to several other parts of the paper. Liquidity and Treasury Risk is the closest link, since repo funding is a core liquidity source and a core liquidity risk. Credit risk shows up through counterparty exposure and collateral. Market risk shows up through collateral price moves. Investment management questions use repos for leverage. Current Issues topics such as private credit and digital assets also touch collateral and funding stress.

Repo questions are applied and cross several topics, so one good grasp of the mechanics helps you answer items in liquidity, credit and investment management too. GARP tends to test whether you can calculate a simple cash flow or haircut and then interpret the risk, for example why a rise in haircuts forces deleveraging. The material is compact and logical, so it rewards effort more than most chapters. Candidates who learn the cause-and-effect chain of a repo run can answer many scenario questions without memorising detail.

Repurchase Agreements and Financing: topics in the order to study them

  1. 1Repurchase Agreement MechanicsStart here because every later idea depends on knowing the two legs, the repo rate, the haircut and who is lending cash versus collateral.
  2. 2Repo Market Structure and SettlementNext, learn who participates and how trades settle (bilateral, tri-party, central clearing), since structure explains where risk sits.
  3. 3Repo Financing and Collateral UseOnce structure is clear, study why dealers and funds use repos for leverage, financing and sourcing specific securities.
  4. 4Repo Risks and Run DynamicsWith the uses understood, you can see how haircuts, collateral value and rollover risk combine into funding runs.
  5. 5Repo Regulation and Liquidity ManagementFinish with the policy response, which only makes sense after you understand the risks it targets.

How to prepare Repurchase Agreements and Financing

Treat this chapter as one story: how a secured loan works, how it is used, how it breaks and how rules respond. Build it in that order.

  1. Write out one repo with numbers: security value, haircut, cash lent, repo rate, term and repurchase price. Redo it until you can do it without notes.
  2. Learn the simple interest calculation: interest = cash × repo rate × days ÷ basis. The basis is typically 360 for USD and 365 for GBP. Always use the one stated in the question.
  3. Draw the cash and collateral flows for bilateral, tri-party and centrally cleared repos, and note who bears which risk in each.
  4. Practise the haircut logic: cash lent = collateral value × (1 − haircut). Then ask what happens to funding when the haircut rises or the collateral price falls.
  5. Build a run chain in your own words: collateral stress, higher haircuts, margin calls, forced asset sales, further price falls. Repeat it for different scenarios.
  6. Link regulation to risk: match each measure, such as central clearing or liquidity requirements, to the specific weakness it addresses.
  7. Finish with timed mixed questions that combine repo with liquidity, credit and investment topics, and review every wrong answer.

Common mistakes in Repurchase Agreements and Financing

  • Mixing up who is the borrower and who is the lender in a repo and reverse repo.

    Fix: Always track cash. Whoever receives cash at the start is the borrower, whichever name the question uses.

  • Applying the haircut the wrong way round.

    Fix: Define the haircut as (collateral value − cash lent) ÷ collateral value. Then cash lent = collateral value × (1 − haircut), and the collateral needed is cash ÷ (1 − haircut). Some questions instead define a margin over cash, which gives collateral = cash × (1 + margin). Check which definition the question uses.

  • Ignoring the day-count convention when calculating repo interest.

    Fix: Use the basis stated in the question. It is typically 360 for USD and 365 for GBP. If none is given, state your assumption and apply it consistently.

  • Treating repo as risk-free because it is collateralised.

    Fix: Ask what happens if the collateral falls in value, the borrower defaults or funding cannot be rolled over.

  • Describing runs as credit events only.

    Fix: Explain the chain: collateral stress, haircut increases, margin calls, asset sales and further price declines, even for a borrower that is still solvent.

  • Memorising regulations without linking them to the risk they target.

    Fix: For each rule, state the weakness it addresses, such as bilateral exposure, procyclical haircuts or short-term funding dependence.

Last-day revision: Repurchase Agreements and Financing

  • A repo is a sale plus a forward repurchase, economically a secured loan.
  • The cash borrower is the seller of the security; the cash lender receives the collateral.
  • A reverse repo is the same trade seen from the cash lender's side.
  • Repo interest = cash × repo rate × days ÷ day-count basis.
  • Cash lent = collateral value × (1 − haircut), so a higher haircut means less cash for the same collateral.
  • Haircuts protect the lender against a fall in collateral value during the term.
  • Tri-party repos use a third-party agent to hold collateral and handle settlement and substitution.
  • Central clearing reduces bilateral counterparty exposure and allows netting, but concentrates risk in the clearing house.
  • Most repos are short term, so borrowers face rollover risk.
  • Rising haircuts and falling collateral prices can force deleveraging and fire sales.
  • Repo runs resemble bank runs: lenders withdraw funding when confidence in collateral or the borrower drops.
  • Liquidity standards and buffers aim to reduce reliance on fragile short-term secured funding.

Repurchase Agreements and Financing practice questions

Repurchase Agreements and Financing in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Repurchase Agreements and Financing: frequently asked questions

Is the repo chapter calculation heavy in FRM Part II?

No. Calculations are usually simple, such as repo interest, cash lent after a haircut or a margin shortfall. The harder part is interpreting what the numbers mean for liquidity and counterparty risk.

How is a repo different from a secured loan?

Legally a repo is a sale with a repurchase agreement, while economically it works like a secured loan. Title to the collateral transfers to the cash lender. In many jurisdictions repos also get safe-harbour treatment, so the lender can sell the collateral immediately on default without being caught by the bankruptcy stay.

Why do haircuts matter so much in repo run questions?

A higher haircut cuts the cash a borrower can raise against the same collateral. In stress, haircuts tend to rise, which forces borrowers to find extra funds or sell assets, and that can deepen the run.

How much time should I spend on this chapter?

Give it a focused block, as it connects to liquidity, credit and investment management topics. Spend most of it on the mechanics and the run chain, then use mixed practice to link it to the rest of the paper.