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

In the 2007-2008 repo market, a dealer financed a bond with a 2% haircut. The haircut then rose to 10% on the same collateral, valued at USD 100 million. By how much did the cash the dealer could raise against the collateral fall?

Borrowing capacity equals collateral value times one minus the haircut. At a 2% haircut the dealer raises USD 98 million; at 10% it raises USD 90 million. The reduction is USD 8 million, which must be replaced with other funding or by selling assets.

  1. AUSD 2 million
  2. BUSD 8 millionCorrect
  3. CUSD 10 million
  4. DUSD 12 million

Explanation

Cash raised = collateral x (1 - haircut). Before: 100 x 0.98 = USD 98 million. After: 100 x 0.90 = USD 90 million. The fall is USD 8 million. USD 10 million wrongly uses only the new haircut, ignoring the original funding.

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