Repo Risks

Repo risks

Repo trades involve credit risk, market risk, liquidity risk and operational risk the counterparties involved. In the following the term "buyer" refers to the party that receives the collateral at the start of the trade and the term "seller" refers to the party receiving cash at the start of the trade:

The seller:

Market Risk

The seller of the collateral is obliged under the repo agreement to repurchase the securities on the maturity of the deal. The repurchase price is fixed. Therefore the seller retains the market risk on the collateral during the period of the repo.

There is a secondary market risk related to the repo rate on the trade. The seller pays repo interest at the agreed rate. If the repo rate in the market place falls after the deal is struck the seller is paying a rate that is higher than the market rate.

Credit Risk

The seller of the collateral is obliged under the repo agreement to repurchase the securities on the maturity of the deal. The repurchase price is fixed. Therefore the seller retains the credit risk on the collateral during the period of the repo.

The seller may also have a credit risk on the buyer. This can occur because a haircut has been applied to the deal (the deal is over collateralised) or the collateral has increased in market value.

The buyer:

Market risk

If the seller defaults on the transaction the buyer would need to liquidate the collateral in order to obtain repayment. If the value of the collateral has fallen the buyer may be holding collateral of insufficient value. It is for this reason that buyers apply haircuts and call margins.

There is a secondary market risk related to the repo rate on the trade. The buyer receives the repo interest at the agreed repo rate. If the repo rate in the market place rises after the deal is struck the buyer is receiving a rate that is lower than the market rate.

Credit risk

The buyer has credit risk on the seller for the repo principal and interest amount. If the seller defaults the collateral becomes the buyer's source of repayment. The buyer should therefore consider the collateral provided and in particular any correlation in credit risk it has with the seller.

Liquidity Risk

If the collateral is illiquid it may be difficult to sell. Illiquid collateral is therefore less attractive for the buyer who may impose a larger haircut in order to mitigate this risk.

Foreign Exchange Risk

If the collateral is denominated in a currency that is different from the cash exchanged in the repo a further risk is incurred. In the event that the collateral is relied on its value may be insufficient because the foreign exchange rate may have moved adversely.

First Published by Barbican Consulting Limited 2010