Author Abstract
This paper develops a parsimonious static model for characterizing financing terms in collateralized borrowing markets. We characterize the systematic risk exposures for a variety of securities and develop a simple indifference-pricing framework to value the systematic crash risk exposure of the collateral. We then apply Modigliani and Miller's (1958) Proposition Two (MM) to split the cost of bearing this risk between the investor and the intermediary broker, resulting in a schedule of haircuts and financing rates. The model produces comparative statics and time-series dynamics that are consistent with the empirical features of repo market data, including the credit crisis of 2007-2008.
Paper Information
- Full Working Paper Text
- Working Paper Publication Date: April, 2010
- HBS Working Paper Number: 11-025
- Faculty Unit(s): Finance