In a typical say 1 week bond repo deal , as i understand , typically X units of bonds are exchanged for P.X cash at spot date (P=dirty price of bond) , and in 1 week , X units of bonds are returned, and cash of P.(1 + repo*T).X is paid.

BUT , sometimes , a haircut / "overcollateralisation" is done , and so actually at inception 1.05X units are exchanged for P.X cash , and at maturity 1.05Xunits are rturned for P.(1+repo*T).1.05X (like in Lehmans repo105 deal)

What i dont understand here is a) why is it always that it's OVERcollateralisation thats done - and its never UNDercollateralisation? after all , in the repo deal , it can be thought of as an exchange of 2 loans, 1 party borrowing cash and posting bond collateral and the other party borrowing bonds and posting cash collateral, and which ever party is riskier should put up more collateral, so if the party that borrows bonds is riskier, then the deal should be UNDercollateralised - ie P.X cash should be exchanged for 0.95 X units of bonds.

b) the repo rate must depend on the degree of overcollateralisation , ie on how off market the spot deal is , since for the whole repo deal to be fair , the forward deal must be sufficiently out of the-money to compensate for how much the spot deal is in the money. so , when repo rates are reported , why is the degree of collateralisation not indicated? perhaps the answer is that everyone knows the degree of collateralisation, and that it does not change much between dealers , and doesnt have much impact on the rate ?

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  • $\begingroup$ (1)It is a COLLATERALIZED loan, so credit risk of parties is not very relevant. (2) I have a widget worth 100 that experts say could be worth 101 or 99 in the near future, how much are you willing to lend me on this collateral 101 or 99? (3) I give USD 20 bill to a grocer to pay for my food, how much is the cashier going to ring up on the register: 21, 20 or 19? Does it vary according to my creditworthiness? $\endgroup$ – noob2 Feb 16 '17 at 20:23
  • $\begingroup$ 1) i am assuming there are no daily collateral calls so there is risk, 2) what if the bond price goes way up. and then the guy that you lent the bond to "fails" , ie decides not to return the bond to you. well i suppose you would think that in hindsight you should have UNDercollateralised rather than OVERcollateralising , right? 3) the spot transaction is just half the transaction , dont forget the forward transaction! the requirement is just that the Net PV is zero ! $\endgroup$ – Randor Feb 16 '17 at 20:58
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    $\begingroup$ The question about overcollateralization is a fair one. I think it's because the market started off with people wanting to buy bonds, and get financing. The lenders would only lend 95c on the bond value. $\endgroup$ – dm63 Feb 17 '17 at 0:28

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