haircut and leverage
- Thread starter ajsa
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Hi asja,
They are directly related: 1/haircut = leverage.
The repos Gorton refers to are basically borrowing (i.e., using the bought security as collateral for the repo).
Say you can get a 20% return on $100 face bond,
but you borrow instead to leverage up the return...(in the repo, you buy the $100 bond then use it as collateral to borrow the $100 used to pay for the bond; that's if the haircut is 0%).
a 10% haircut means your repo dealer will lend you $90 against the $100: so you need still only need $10 of your money to control 20% return on $100 (i.e., 10X leverage). So with 10% haircut, your return is $20 (20% on $100: $90 of which is borrowed) on $10 of your own capital. A 200% return which is 10X the 20% (10X leverage)
if dealer doubles haircut to 20%, then you need $20 to control $100 (5X leverage) and it may as well be a margin call.
hope that helps...the FRM totally forgets to introduce repos (?!)...David
They are directly related: 1/haircut = leverage.
The repos Gorton refers to are basically borrowing (i.e., using the bought security as collateral for the repo).
Say you can get a 20% return on $100 face bond,
but you borrow instead to leverage up the return...(in the repo, you buy the $100 bond then use it as collateral to borrow the $100 used to pay for the bond; that's if the haircut is 0%).
a 10% haircut means your repo dealer will lend you $90 against the $100: so you need still only need $10 of your money to control 20% return on $100 (i.e., 10X leverage). So with 10% haircut, your return is $20 (20% on $100: $90 of which is borrowed) on $10 of your own capital. A 200% return which is 10X the 20% (10X leverage)
if dealer doubles haircut to 20%, then you need $20 to control $100 (5X leverage) and it may as well be a margin call.
hope that helps...the FRM totally forgets to introduce repos (?!)...David
i am liking that analogy in many respects; e.g., repo dealers increasing haircut ~ mortagage lenders reverting from 0% down to more traditional 10%/20% down (with price impact)!
Hi asja,
I think this little formula by Gorton is a bit of a gold nugget touching on other themes: in foundations, Jorion (Ch 1) says the essential characteristic of derivatives is their *leverage* which is two-edged: efficient but hard to value the exposure. In the case of the CDS, the "efficiency" is the fact that it is (aside from collateral) *unfunded." Can there be any doubt the CDS market grew so rapidly, at least in part, because protection sellers did not have to fund (i.e., invest like they would in a bond)?
... the unfunded synthetic exposure (sell credit protection) is long the reference just like investing in the bond, but the critical difference is that to invest in the bond, you need to pay (fund) the principal
so, this Gorton formula adds an *improvement* to the naive expression that: long risky bond yield should = riskless yield + CDS premium
(i.e., long risky bond is same as long treasury + short CDS)
...this naive formula omits funding risk and cost of funding
actually, Moorad Choudhry (CDS basis) explains well:
"Funding versus Libor [as a factor impacting the CDS basis]: the funding cost of a bond plays a significant part in any trading strategy associated with it in the cash market. As such, it is a key driver of the ASW spread. A cash bond investor will need to fund the position, and we take the bond’s repo rate as its funding rate. The funding rate, or the bond’s cost-of-carry, will determine if it is worthwhile for the investor to buy and hold the bond. A CDS contract, however, is an unfunded credit derivative that assumes a Libor funding cost. So an investor who has a funding cost of Libor plus 25 basis points will view the following two investments as theoretically identical:
* Buying a floating-rate note priced at par and paying Libor plus 125 bps
* Selling a CDS contract on the same FRN at a premium of 100 bps"
David
I think this little formula by Gorton is a bit of a gold nugget touching on other themes: in foundations, Jorion (Ch 1) says the essential characteristic of derivatives is their *leverage* which is two-edged: efficient but hard to value the exposure. In the case of the CDS, the "efficiency" is the fact that it is (aside from collateral) *unfunded." Can there be any doubt the CDS market grew so rapidly, at least in part, because protection sellers did not have to fund (i.e., invest like they would in a bond)?
... the unfunded synthetic exposure (sell credit protection) is long the reference just like investing in the bond, but the critical difference is that to invest in the bond, you need to pay (fund) the principal
so, this Gorton formula adds an *improvement* to the naive expression that: long risky bond yield should = riskless yield + CDS premium
(i.e., long risky bond is same as long treasury + short CDS)
...this naive formula omits funding risk and cost of funding
actually, Moorad Choudhry (CDS basis) explains well:
"Funding versus Libor [as a factor impacting the CDS basis]: the funding cost of a bond plays a significant part in any trading strategy associated with it in the cash market. As such, it is a key driver of the ASW spread. A cash bond investor will need to fund the position, and we take the bond’s repo rate as its funding rate. The funding rate, or the bond’s cost-of-carry, will determine if it is worthwhile for the investor to buy and hold the bond. A CDS contract, however, is an unfunded credit derivative that assumes a Libor funding cost. So an investor who has a funding cost of Libor plus 25 basis points will view the following two investments as theoretically identical:
* Buying a floating-rate note priced at par and paying Libor plus 125 bps
* Selling a CDS contract on the same FRN at a premium of 100 bps"
David
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