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

A hedge fund borrows cash in repo against a bond with a 10% haircut and uses the proceeds to buy more of the same bond, repeating until fully leveraged. What is the maximum leverage ratio (total assets to equity) achievable, and what happens if the haircut rises to 20%?

With repo financing, equity must cover the haircut on each unit of assets, so maximum assets-to-equity leverage equals one divided by the haircut. A 10% haircut gives 10 times leverage, and a 20% haircut cuts it to 5 times, forcing deleveraging.

  1. AMaximum leverage is 10 times; it falls to 5 times at a 20% haircutCorrect
  2. BMaximum leverage is 9 times; it falls to 4 times at a 20% haircut
  3. CMaximum leverage is 10 times; it falls to 8 times at a 20% haircut
  4. DMaximum leverage is 11 times; it falls to 6 times at a 20% haircut

Explanation

Each unit of bond needs equity equal to the haircut, so leverage = 1/haircut: 1/0.10 = 10 and 1/0.20 = 5. Option 1 subtracts one (assets minus equity, which is debt-to-equity), so it is wrong as a ratio of assets to equity.

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