In the quote below, why'd Steve offer $10.5, when your Air Jordans are worth \$11? Why wouldn't Steve (the lender) assign the collateral haircut to you, and require you to pay him \$11 + risk premium?

Apologies for the lengthy quote : please advise how I can shorten it.

ELI5: Repos, reverse repos, bonds & how they correlate. : investing

It's lunch time and you're sitting in the cafeteria wearing your special edition purple and gold Air Jordans when you realize that you forgot your wallet at home. You need your wallet so that you can buy food. Or maybe you need your wallet so you can repay Jimmy for the sandwich he bought you last week.

You got to your friend Steve who comes from a rich family and is always carrying extra cash around. You want to see if Steve will lend you some money if you promise to pay him back tomorrow. Steve is no dummy--he knows if you forgot your wallet today you might forget it tomorrow. So he offers to give you \$10 for lunch if you pay him back \$11 tomorrow. The extra \$1 is interest you pay Steve for trusting that you will pay him back.

\$1 seems like a lot of money for one day to you. But you do need to eat so you don't have a lot of options. You don't have your wallet. But you do have your Air Jordans. Let's say your Air Jordan's are worth exactly \$11.

You offer to let Steve hang on to your Air Jordans as a guarantee that you will pay him back tomorrow. If you don't pay him back--he gets to keep your shoes. The Air Jordans are what is called collateral. Steve agrees to this because he knows if you don't pay him back, someone else will buy the Air Jordans from him immediately for a market price of \$11.

$\color{red}{\text{Steve offers you a new deal.}}$ In exchange for holding on to your Air Jordans, he will give you (immediately) a \$10 bill with the obligation that you will buy back the Air Jordans from him tomorrow for \$10.50.

Two things have happened here. Firstly, Steve is giving you \$10 to hold on to an \$11 pair of shoes. How can he get away with this? Well--Steve is assuming the risk that Nike announces overnight that the Air Jordans are undergoing a recall and the value goes to \$0. Exchanging shoes as collateral for a loan at less than the market value is called a collateral haircut. The haircut is meant to account for the risk that the collateral asset might lose considerable valuable before the end of the loan. In this case the haircut was 1/11 = 9.1%.

Next, you are still paying \$10.5 back to Steve tomorrow. This new rate of interest (\$.5/\$10 = 5%) is called the repo rate. This is 50% smaller than the loan Steve offered without a collateral backing (\$1/\$10 = 10%). Steve is still charging a "premium" for the possibility that you don't pay him back tomorrow (a default) and the opportunity cost he is experiencing by not investing his \$10 in something else.

This entire transaction (exchanging the Air Jordans for \$10 and repaying \$10.50 the next day and receiving back the Air Jordans) is called an overnight Repo transaction. Overnight is indicative of the term of the repo. A term repo could be an agreement over a longer period of time.

In this case, Steve has performed a reverse Repo. Typically dealers and other large financial institutions use repos to generate liquidity--getting cash (\$\$) in exchange for an asset (Air Jordans)-- or to achieve leverage by using their current assets to secure a loan that is used to buy another asset-- using the cash from the Air Jordans repo to buy a second pair of Air Jordans--.


Why'd the lender suffer the collateral haircut

This is not an accurate way of describing what is happening. No one "suffered". The collateral was entered at lower than current market value, to account for the risk. It can also be repossessed from Steve at lower than current market value.

Why wouldn't Steve (the lender) assign the collateral haircut to you, and require you to pay him $11 + risk premium?

That would have also been acceptable to Steve. As it is explained in the text

$1 seems like a lot of money for one day to you. But you do need to eat so you don't have a lot of options.

So it is in fact you who did not want to pay the risk premium, and Steve went along with your alternate offer.


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