FRM Exam Part II · Repurchase Agreements and Financing

Repo Risks and Run Dynamics for FRM Part II

Updated 11 October 2026 · Fact-checked

Repo risk is the chance that short-term secured funding disappears or becomes costlier. Lenders can refuse to roll over, raise haircuts or cut counterparties. Borrowers then sell assets at falling prices, which lowers collateral values and triggers more haircuts. To solve questions, trace this loop: shock, haircut, forced sale, price fall.

Understand Repo Risks and Run Dynamics

A repurchase agreement (repo) is a sale of securities with a promise to buy them back later at a higher price. Economically it is a collateralised loan. The cash lender holds the securities as protection. Most repos are overnight or short term, so the borrower must roll over the loan again and again.

Rollover risk is the risk that the lender will not renew. A dealer funding long-dated assets with overnight repo has a maturity mismatch. If lenders step back, the dealer must find cash that day or sell assets. Secured does not mean safe: the lender is protected only if the collateral can be sold for at least the loan amount.

The haircut is the gap between collateral value and cash lent. Haircut = (collateral value − cash lent) ÷ collateral value. A 5% haircut means the borrower funds 5% of the asset with its own capital. Haircuts are procyclical. In calm markets they are low, so leverage rises. In stress, volatility and uncertainty rise, lenders raise haircuts, and the borrower needs more equity or must sell assets. This is a margin spiral (or haircut spiral): higher haircuts force sales, sales push prices down, lower prices and higher volatility prompt still higher haircuts.

A fire sale is a forced sale at prices below fundamental value because the seller needs cash quickly and buyers are scarce. Fire sales spill over: other holders of the same assets suffer mark-to-market losses and face their own margin calls. Counterparty risk adds to this. Lenders worry about the borrower's solvency and about whether collateral can be liquidated cleanly, especially for illiquid or complex collateral.

In 2007-2009 the run was on the repo market rather than on retail deposits. Gorton and Metrick described it as a run on repo. Haircuts on structured credit collateral rose sharply, and some collateral was no longer accepted. Dealers dependent on short-term funding, such as Bear Stearns and Lehman Brothers, lost funding. Lenders were also concerned about being stuck with collateral in bankruptcy. Central bank liquidity facilities were then used to stop the run.

Key formulas to remember

Haircut: Haircut = (Collateral value − Cash lent) ÷ Collateral value; Cash lent = Collateral value × (1 − Haircut).
Borrower equity funding: Equity needed = Asset value × Haircut; Borrower must fund this from its own capital.
Maximum leverage from haircut: Maximum leverage = 1 ÷ Haircut; Assets ÷ equity. A 5% haircut gives 20 times; a 10% haircut gives 10 times.
Funding gap after a haircut rise: Gap = Asset value × (New haircut − Old haircut); Extra cash needed to keep the same assets funded, if the asset price is unchanged.
Margin spiral loop: Shock → higher volatility → higher haircut → forced sales → lower prices → losses → higher haircut; Qualitative rule; recall the sequence for conceptual questions.

How to solve Repo Risks and Run Dynamics questions

Use this order for any repo risk question, numeric or conceptual.

1Identify the risk type: rollover, collateral valuation, haircut procyclicality, counterparty or fire-sale spillover.
2Identify who is the cash borrower and who is the cash lender, and what collateral backs the loan.
3If numbers are given, apply Haircut = (Collateral − Cash) ÷ Collateral. Compute cash lent and equity needed.
4For a haircut change, compute the funding gap on the same asset value, then the asset sale needed to close it.
5Check whether the sale itself moves prices, which would feed back into collateral value and haircuts.
6Link to the crisis: short-term funding of long-term or illiquid assets, rising haircuts, loss of lender confidence.
7Pick the answer that names the mechanism precisely. Reject options that call repo risk-free or confuse haircut with margin call.

Quickest way: Haircut gap shortcut

When to use it: Numeric questions on higher haircuts, funding shortfalls or deleveraging.

Gap = Asset value × change in haircut.
If the question asks for assets sold with no equity added, new assets = equity ÷ new haircut.
Assets to sell = old assets − new assets.
For conceptual items, look for the keywords: procyclical, rollover, fire sale, spiral.

Common mistakes in Repo Risks and Run Dynamics

Treating the haircut as a percentage of cash lent.
The word is used loosely and the base is easy to mix up.
Fix: The base is collateral value. Cash lent = collateral × (1 − haircut).
Saying repo is safe because it is collateralised.
Students focus on credit risk and ignore liquidity and collateral value risk.
Fix: Collateral protects only if it can be sold at or above the loan. Rollover and haircut risk remain.
Describing haircuts as countercyclical.
Students think of buffers that should build in good times.
Fix: Market haircuts are procyclical: low in booms, high in stress. That amplifies leverage swings.
Assuming a fall in collateral price is the only cause of a repo run.
Price-based thinking is familiar from VaR.
Fix: Runs can be triggered by uncertainty about collateral or counterparty, even before prices drop.
Subtracting new leverage wrongly: using haircut × cash instead of haircut × asset.
Confusing the loan with the asset.
Fix: Equity needed is always asset value × haircut.

Worked examples

Example 1

A dealer holds a bond worth $200 million funded by overnight repo at a 4% haircut. The haircut rises to 10% and the bond price is unchanged. The dealer has no spare cash. How much of the bond must it sell, assuming it keeps its equity fixed?

Show the solution

Original cash lent = 200 × (1 − 0.04) = $192 million.
Original equity = 200 × 0.04 = $8 million.
With a 10% haircut and equity of $8 million, supportable assets = 8 ÷ 0.10 = $80 million.
Assets to sell = 200 − 80 = $120 million.

Answer: The dealer must sell $120 million of the bond (60% of the position).

Example 2

A bank lends $90 million against collateral worth $100 million. A stress event leads it to demand a 15% haircut at rollover on the same collateral, price unchanged. How much extra cash must the borrower provide?

Show the solution

Original haircut = (100 − 90) ÷ 100 = 10%.
New cash lent = 100 × (1 − 0.15) = $85 million.
Cash shortfall = 90 − 85 = $5 million.
Check: 100 × (0.15 − 0.10) = $5 million.

Answer: The borrower must provide an extra $5 million at rollover, or sell collateral to raise it.

Exam tips

Know the sequence of the margin spiral and be able to spot which step a question describes.
For numeric items, always take the haircut base as collateral value.
Questions on 2007-2009 usually test that the run was on short-term wholesale secured funding, with haircuts rising and collateral being questioned.
Distinguish rollover risk (funding disappears) from counterparty risk (borrower defaults) and from collateral valuation risk.
Read options carefully for absolutes such as always or never.

Practice questions from Repurchase Agreements and Financing

Repo Risks and Run Dynamics: frequently asked questions

What is a fire sale in repo markets?

It is a forced sale of collateral at depressed prices because the borrower must raise cash fast. The sales lower prices for similar assets. That hurts other holders and can trigger further haircut increases.

Why are repo haircuts procyclical?

In calm periods low volatility and good liquidity allow low haircuts and high leverage. In stress, volatility and uncertainty rise, so lenders raise haircuts. That forces deleveraging exactly when markets are weak.

What is rollover risk in repo funding?

It is the risk that a short-term repo cannot be renewed on the same terms or at all. The borrower then needs other cash or must sell assets. It is greatest when long-term or illiquid assets are funded overnight.

How did the repo run in the 2007-2009 crisis work?

Lenders raised haircuts and refused some collateral, particularly structured credit. Dealers reliant on repo lost funding and had to sell assets. Doubts about solvency, as with Bear Stearns and Lehman Brothers, accelerated the run.