Repos, Risk Aversion, and Haircuts

Abstract

Repurchase agreements ("repos") play a significant role in global credit market activity. Therefore, the individual decisions of repo market participants can weigh heavily on the broader economy. In order to analyze the decisions of these participants, our framework studies security repurchase agreements between risk-averse borrowers and lenders. In this manner, repo agreements are part of an efficient risk-sharing arrangement. In turn, properties of the agreements depend on environmental conditions such as the degree of risk aversion, default risk, and the market value of collateral. Previous work based upon risk neutrality cannot capture these features. Haircuts, in particular, arise naturally in the model in order to promote risk-sharing. From this perspective, our work is in stark contrast to previous contributions which determine the extent of over-collateralization in response to asymmetric information between market participants.

Keywords: Repurchase Agreements, Haircuts, Risk Sharing, Risk Aversion

JEL Classification: E44, G10, G24