Repo haircuts and economic capital: a theory of repo pricing

Wujiang Lou

Journal of Credit Risk

Abstract: Repo pricing is characterized by its puzzling dual pricing measures: the repo haircut and the repo spread. This paper develops a repo haircut model by designing haircuts to satisfy preset credit criterions and identifies economic capital for repo default risk as the main driver of repo spreads. A simple linear formula is obtained that relates repo spreads to haircuts. An investor wishing to minimize their all-in funding cost can settle at an optimal combination of the haircut and repo rate. The model corroborates stylized facts, such as triparty repo haircuts’ insensitivity to counterparties, the differences between triparty and bilateral haircuts, and the lenders’ shortening repo tenor when market stress is developing.

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