Haircut, Interest Rate, and Collateral Quality in the Tri-Party Repo Market: Evidence and Theory

Abstract

Leveraging transaction-level data from the Korean tri-party repo market, we analyze how contract terms interact with collateral quality. Both haircuts and interest rates rise with collateral risk, consistent with existing research. However, conditioning on collateral quality, we find a trade-off: a 1% point increase in the interest rate is associated with a 1.3% point reduction in the haircut. The same interest rate increase corresponds to a smaller reduction in the haircut under heightened market uncertainty, indicating that insurance instruments become more crucial as default risk increases. We demonstrate that the interaction between information acquisition incentives and borrowers' opportunistic default risk explains the positive (negative) unconditional (conditional) relationship between haircuts and interest rates.

Keywords: Repo market, Collateralized debt, Haircut, Collateral quality, Costly Information acquisition, Uncertainty