Conversely, suppose the investor (i.e., the lender) defaultssuch that the investor fails to deliver the Treasuries on the repurchase date. The risk is that Treasury yields have fallen over the agreements life such that the dealer now holds an amount of dollars worth less then the market value of collateral. In this instance, the investor is liable for any excess of the price paid by the dealer for replacement securities over the repurchase price.5

Repo Margin

While both parties are exposed to credit risk in a repo transaction, the lender of funds is usually in the more vulnerable position. Accordingly, the repo is structured to reduce the lenders credit risk. Specifically, the amount lent should be less than the market value of the security used as collateral, thereby providing the lender some cushion should the collat- erals market value decline. The amount by which the market value of the security used as collateral exceeds the value of the loan is called repo margin or "haircut." Repo margins vary from transaction to transaction and are negotiated between the counterparties based on factors such as the following: term of the repo agreement, quality of the collateral, cred- itworthiness of the counterparties, and the availability of the collateral. Minimum repo margins are set differently across firms and are based on models and/or guidelines created by their credit departments. Repo mar- gin is generally between 1% and 3%. For borrowers of lower credit wor- thiness and/or when less liquid securities are used as collateral, the repo margin can be 10% or more.

At the time of this writing, the Basel Committee on Banking Supervi- sion is proposing standards for repo margins for capital-market driven transactions (i.e., repo/reverse repos, securities borrowing/lending, derivatives transactions, and margin lending).6These standards would only applytobanks.

5See Section 11 "Events of Default" of the Master Repurchase Agreement repro- duced in the appendix to this chapter.

6The revised Basel Accord is in exposure draft form until May 31, 2001 and the final document will be published before June 30, 2002.

To illustrate the role of a haircut in a repurchase agreement, let us once again return to the government securities dealer who purchases a 5% coupon, 10-year Treasury note and needs financing overnight. Recall, the face amount of the position is $1 million and the notes full price (i.e., flat price plus accrued interest) is $1,044,843.75. As before, we will use Bloombergs RRRA screen to illustrate the transaction in Exhibit 8.2.

When a haircut is included, the amount the customer is willing to lend is reduced by a given percentage of the securitys market value. In