How do repo haircuts work and what determines their size?
I'm studying repos for FRM Part I and I understand the basic mechanics — sell security, agree to repurchase later. But what exactly is a 'haircut' and why do different securities have different haircut levels?
A repurchase agreement (repo) is essentially a collateralized short-term loan. The haircut is the key risk management mechanism that protects the cash lender.
What is the haircut?
The haircut is the difference between the market value of the collateral and the cash lent. It serves as a buffer against potential declines in collateral value.
Haircut = (Market Value of Collateral - Cash Lent) / Market Value of Collateral
Example: Sentinel Bank enters a repo with Apex Securities, posting $10M face value of US Treasury bonds (current market value = $10.2M) as collateral.
- With a 2% haircut: Cash lent = $10.2M × (1 - 0.02) = $9.996M
- Sentinel receives $9.996M in cash; Apex holds $10.2M in treasuries as collateral
- The $204K difference ($10.2M - $9.996M) protects Apex if treasury prices fall
What determines haircut size?
| Factor | Low Haircut | High Haircut |
|---|---|---|
| Collateral quality | US Treasuries (0.5-2%) | Corporate bonds (5-15%) |
| Collateral liquidity | On-the-run bonds | Off-the-run or illiquid securities |
| Maturity | Short-term (<1yr) | Long-term (>10yr) |
| Credit quality | AAA rated | Below investment grade |
| Volatility | Low vol environment | High vol / crisis |
| Counterparty risk | Large dealer (low) | Small hedge fund (high) |
| Repo term | Overnight | Term (weeks/months) |
Typical haircut ranges:
| Collateral Type | Typical Haircut |
|---|---|
| US Treasury bills | 0.5-1% |
| US Treasury bonds | 1-3% |
| Agency MBS | 2-5% |
| Investment-grade corporates | 5-10% |
| High-yield bonds | 10-25% |
| Equities | 15-25% |
| Structured products (ABS/CDO) | 10-50% |
Procyclicality problem:
During financial crises, haircuts spike dramatically as lenders become more cautious. In 2008:
- Haircuts on non-agency MBS went from 5% to 40-50%
- This forced borrowers to either post more collateral or repay the loan
- This deleveraging spiral amplified the crisis — the "repo run"
Exam tip: FRM Part I frequently tests the relationship between collateral quality and haircut size, and the systemic risk implications of procyclical haircuts.
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