The collaterals used in the repo market are high quality securities; but they are also not free from credit risk. In our earlier example, we see the dealer borrowing Rs.1 crore using the purchased securities as collateral. If, for any reason, the dealer is unable to buyback the securities, the customer is left with securities. If the interest rates increase the market value of the government securities would decrease, leaving the customer with securities worth less than the loaned amount. If the interest rates decline, the value of the collateral would be greater than the loaned amount and the dealer is concerned about the return of the securities. Therefore repos should be carefully structured to reduce credit risk exposure. The amount lent to the borrower should always be less than the current market value of the security. The amount by which the market value of the securities exceeds the loan amount is termed as repo margin or margin. This margin gives a little cushion to the lender in case the interest rates increase as it would lead to decline in the market value of the securities. Generally, an amount between 1% to 3% of the market value of the securities is maintained as margin. For less liquid or price sensitive securities the margin could be as high as 10% or more.
Illustration
Amount needed by the dealer = Rs.10,00,000
Repo rate = 0.06
Repo term = 1 day
Margin = 2%.
Therefore, the margin in absolute terms would be 2% of 10, 00,000, i.e. Rs. 20,000
Amount borrowed = Rs.9, 80,000
The interest charged would be on the amount borrowed i.e. 9, 80,000 and not on 10,00,000.
The interest payable would be:
Interest = 9, 80,000 x 0.06 x 1/ 360 = Rs.163.33.
Credit risk involved in these transactions can also be reduced by marking collaterals to market on a regular basis. This process is known as mark-to-market. The value of a position at its market value is recorded daily and compared to its initial price. When the market value declines this would result in a deficit. The customer would ask the borrower to take care of the margin deficit by providing additional cash or securities which can be used as collateral. Similarly, if the market value of the securities increases, the customer may transfer the excess margin to the borrower in form of cash or securities.