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

Author

Listed:
  • Sangyup Choi

    (Department of Economics, Yonsei University)

  • Inkee Jang

    (Department of Economics, The Catholic University of Korea)

  • Kee-Youn Kang

    (Department of Economics, University of Liverpool)

  • Hyunpyung Kim

    (Department of Economics, Yonsei University)

Abstract

Leveraging the universe of transaction-level data from the Korean tri-party repo market, we examine how repo contract terms interact with collateral quality. We find that both the haircut and the interest rate increase with collateral risk, consistent with previous findings. However, conditioning on the same collateral quality, we uncover the trade-off between the haircut and the interest rate: A 1% point increase in the interest rate is associated with a 1.3% point reduction in the haircut. Moreover, the rate at which the interest rate substitutes the haircut decreases in market uncertainty, suggesting that the relative importance of insurance instruments increases with default risk. We theoretically show that the interaction between lenders' incentives to acquire information about collateral quality and borrowers' incentives to default opportunistically in a collateralized debt market is key to rationalizing the positive (negative) unconditional (conditional) relationship between the haircut and the interest rate.

Suggested Citation

  • Sangyup Choi & Inkee Jang & Kee-Youn Kang & Hyunpyung Kim, 2024. "Haircut, Interest Rate, and Collateral Quality in the Tri-Party Repo Market: Evidence and Theory," Working Papers 11, University of Liverpool, Department of Economics.
    • Handle: RePEc:liv:livedp:202411
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    File URL: https://www.liverpool.ac.uk/media/livacuk/schoolofmanagement/departmentofeconomics/workingpapers/ECON,WP,202411.pdf
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    Keywords

    Repo market; collateralized debt; haircut; collateral quality; costly information acquisition; uncertainty;
    All these keywords.

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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