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FRM Part II · FRM Exam Part II · Repurchase Agreements and Financing

A bank lends USD 98 million of cash in a reverse repo against bonds with a market value of USD 100 million. What are the haircut, and the effect it has on the cash lender?

The haircut is 2.0% of the collateral's market value, calculated as (100 − 98)/100. It leaves the cash lender overcollateralized, giving a buffer against a fall in collateral value before the loan becomes undersecured. It also reduces the cash the borrower obtains.

  1. AThe haircut is 2.0% of collateral value, and it gives the lender a buffer against a fall in collateral valueCorrect
  2. BThe haircut is 2.04% of collateral value, and it increases the cash the borrower receives
  3. CThe haircut is 2.0% of the cash lent, and it protects the borrower against a fall in collateral value
  4. DThe haircut is 2.0%, and it is returned to the lender as extra interest

Explanation

The haircut is (100 − 98)/100 = 2% of collateral market value. The cash lender is overcollateralized by this margin, so collateral can fall by about 2% before the loan is undersecured. A bigger haircut reduces the cash the borrower gets.

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