Haircuts
Haircuts counteract the possibility of loss due to a drop in value of the securities involved in a repo (and illiquidity and counterparty risk) by reducing the cash received by the seller for a given quantity of collateral.
The lender makes sure that there is more collateral than the amount actually lent, also called margin or over-collateralisation.Example 14.10
A repo with a haircut
If a company has ownership of £20 million of gilts and wishes to raise money for 7 days through the repo market it can do so, but not all of the £20 million can be borrowed. If a 0.95% haircut is imposed on £20 million, given a bond equivalent yield of 0.52167%, the seller receives £19,810,000 in return for £20 million worth of securities being sold in the first leg to the lender. Note that the repo interest is only applied to the lesser amount.
The buyer (lender) pays out £19,810,000, but has securities worth £20 million, and receives interest on the amount of cash actually lent. The buy-back price of a repo with a haircut can then be calculated:
