Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis
University of Zurich - Department of Economics
European Central Bank (ECB)
June 23, 2008
ECB Working Paper No. 909
Swiss Finance Institute Research Paper No. 08-24
A standard repurchase agreement between two counterparties is considered to examine the endogenous choice of collateral, the feasibility of secured lending, and welfare implications of the central bank's collateral framework. As an innovation, we allow for two-sided counterparty risk. In line with empirical observations, it is shown that the most liquid and least risky assets are used as collateral in market transactions first. An endogenous opportunity cost arises from using liquid collateral with the central bank. Conditions are identified such that expected utility increases for all market participants when the central bank accepts a broader range of assets as collateral.
Number of Pages in PDF File: 48
Keywords: counterparty risk, repurchase agreements, collateral, liquidity, haircuts
JEL Classification: G21, E51
Date posted: July 4, 2008
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