Repo Haircuts and Economic Capital. (arXiv:1604.05404v1 [q-fin.PR])

This article presents a model of haircuts and economic capital for repo. We propose a credit approach to solve haircuts such that the exposure to market risk meets a prescribed credit rating scale measured by expected loss. Specifically for securities financing business, a credit risk capital approach is also adopted where the borrower dependent haircut is set to a level such that the resultant credit risk VaR is zero. The repo haircuts model incorporates asset risk, borrower credit risk, wrong way risk, and market liquidity risk. Double exponential jump-diffusion type processes are used to model single asset or portfolio price dynamics. Borrower credit is captured by a log-Ornstein-Uhlenbeck default intensity model. Economic capital defined either as unexpected loss from CVaR or expected shortfall is computed for securities financing transactions with negotiated haircuts, to form the basis to levy a capital charge in pre-trade and to fair value in post-trade. Numerical techniques employing two-sided Laplace transform inversion and maximum likelihood estimation of the jump-diffusion model are applied to compute haircuts of SPX500 index, US corporate bond and CMBS indices. Preliminary findings are that stress period calibrated jump-diffusion models can produce haircuts at the levels of BASEL's supervisory haircuts and that repo economic capital far exceeds expected loss and cost of capital has to be included in repo-style transactions pricing.