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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

A dealer borrows USD 95 million in an overnight repo against securities with a market value of USD 100 million. Which statement correctly describes the haircut and the effect if the haircut rises to 10% on the same collateral, as happened in repo markets during the crisis?

The haircut is 5 percent, since the loan is 95 against 100 of collateral. A rise to 10 percent cuts borrowing capacity to USD 90 million, so the dealer must find USD 5 million of other funding or sell assets, which forces deleveraging.

  1. AThe haircut is 5%; at a 10% haircut the dealer can borrow only USD 90 million, needing USD 5 million more fundingCorrect
  2. BThe haircut is 5%; at a 10% haircut the dealer can borrow USD 105 million
  3. CThe haircut is 95%; the dealer needs USD 5 million more funding at 10%
  4. DThe haircut is 5%; a higher haircut lowers the dealer's funding need by USD 5 million

Explanation

Haircut = (100-95)/100 = 5%. At 10%, the loan is 100 x 0.90 = 90 million, so the dealer must replace 5 million with other funding. Higher haircuts reduce borrowing capacity and raise funding needs, forcing deleveraging.

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