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

A broker-dealer finances a portfolio of corporate bonds through overnight tri-party repos with a 5% haircut. During a market stress episode, the lenders raise the haircut to 12% on the same collateral. Which description best captures the effect on the dealer's funding position?

A higher haircut means less cash is lent against the same collateral. The dealer must replace the shortfall with other funding or liquidity, or sell assets, which is how haircut increases create funding pressure and can trigger fire sales in stressed markets.

  1. AThe dealer can borrow more cash per unit of collateral, because a higher haircut signals a safer transaction
  2. BThe dealer receives less cash per unit of collateral and must fund the difference from other sources or sell assetsCorrect
  3. CThe dealer's funding need is unchanged because the repo rate, not the haircut, determines cash received
  4. DThe dealer's funding cost falls because lenders hold more excess collateral

Explanation

A higher haircut reduces the cash advanced against a given market value of collateral. The dealer must therefore find extra unsecured funding, use unencumbered liquidity, or sell assets. Option 0 reverses the relationship between haircut and cash lent.

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