Haircuts and Repo Economic Capital

Lou, Wujiang

doi:10.2139/ssrn.2725633

Cited by 3 publications

(6 citation statements)

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“…Typically, a proxy bond price index of the same maturity bracket (say 3 to 5 years) is picked and EC is computed. See Lou (2016) for more details.…”

Section: Discussionmentioning

confidence: 99%

“…Equation ( 22) in particular formalizes what street traders have been doing when adding a regulatory capital charge to cost of fund rf, together with an interest margin for profit, to arrive their repo rates. El and Nc are provided by a haircut model that considers the joint dynamics of collateral asset and borrower credit, for instance, Lou (2016), where correlation between the asset return and the credit spread is shown to have only marginal impact. This is due to daily margining and a short MPR.…”

Section: Pde (mentioning

confidence: 99%

“…Section 3 defines economic capital and capital valuation adjustment and links up with the repo economic model (Lou 2016) and derives repo fair value and break-even spread formulae. Section 4 shows repo pricing with examples.…”

Section: Introductionmentioning

confidence: 99%

“…What matters to repos are cost of fund and how much capital is used at what cost, both of which are missing from the above. This shows again the inability of the risk-neutral pricing theory to capture gap risk and economic capital Lou (2016). presents a repo haircuts model and a companion economic capital model linking for the first time haircuts and economic capital to collateral security's price dynamics and borrower's credit spread dynamics.…”

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confidence: 98%

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Gap Risk KVA and Repo Pricing: An Economic Capital Approach in the Black-Scholes-Merton Framework

Lou

2016

SSRN Journal

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Although not a formal pricing consideration, gap risk or hedging errors are the norm of derivatives businesses. Starting with the gap risk during a margin period of risk of a repurchase agreement (repo), this article extends the Black-Scholes-Merton option pricing framework by introducing a reserve capital approach to the hedging error's irreducible variability. An extended partial differential equation is derived with two new terms for expected gap loss and economic capital charge, leading to the gap risk economic value adjustment and capital valuation adjustment (KVA) respectively. Practical repo pricing formulae is obtained showing that the break-even repo rate decomposes into cost of fund and economic capital charge in KVA. At zero haircut, a one-year term repo on main equities could command a capital charge as large as 50 basis points for a 'BBB' rated borrower.

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“…Typically, a proxy bond price index of the same maturity bracket (say 3 to 5 years) is picked and EC is computed. See Lou (2016) for more details.…”

Section: Discussionmentioning

confidence: 99%

Section: Pde (mentioning

confidence: 99%

Section: Introductionmentioning

confidence: 99%

mentioning

confidence: 98%

See 2 more Smart Citations

Gap Risk KVA and Repo Pricing: An Economic Capital Approach in the Black-Scholes-Merton Framework

Lou

2016

SSRN Journal

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“…The interplay among eligibility, pledgeability, and credit-ratings needs in-depth analysis. Therefore, it is crucial to examine the relative contribution of various factors that determine asset pledgeability: the limited pool of pledgeable assets or lack of market infrastructure to support transactions Lou (2016) develops a complementary parametric haircut model to conduct sensitivity tests, capture market liquidity risk, allow idiosyncratic risk adjustments, and incorporate relevant market information. 1 Computational results show potential uses in designing collateral haircuts for collateral agreements, such as credit support annexes.…”

Section: Literature Reviewmentioning

confidence: 99%