Ebook Liquidity Risk, Special Repo Rates, and the Credit Crunch of 2007: An Emprical Analysis
Although there is a large body of empirical work based on the returns U.S. Treasury securities (the “cash” market), there is considerably smaller field of study on the underlying Treasury financing market (the “repo” market as a nickname for the repurchase agreements used for short term lending). Perhaps one of the reasons for the lack of empirical studies is that under normal circumstances the repo market is quite stable compared to the volatility of the yield curve and other cash markets, like stock prices. Under normal market conditions, most Treasuries have a comparable financing rate (the general collateral (GC) rate) with just a handful of issues that are “on special”, meaning that the issue has a financing rate less than the GC rate. Collateral that is on special can vary greatly due to a number of factors such as auction cycles, deliverabilty against futures or derivatives contracts, short covers and short squeezes, and cornering particular issues. As one would imagine in an arbitrage free world, this collateral risk translates into a risk premium that affects the cash price of the security.
The “credit crunch” that began in August 2007 was characterized as a time when highly leveraged institutions and funds came under intense scrutiny as a result of write downs in structured product and derivative securities, particularly in the mortage sector. The write-downs increased the degree of risk management required by investors, regulators, and institutional shareholders. As a result, a number of financial institutions increased their margin requirements. Others reduced their exposure to risky assets and moved to safe haven assets such as Treasuries. These conditions caused a spike in demand for Treasury collateral and cash market prices and repo rates changed accordingly. The number of Treasuries that went on special increased from an average of 5%-10% to over 30%. Several repo rates traded close to zero due to extraordinary demand.
The study of the relationship between the Treasury cash market, the Treasury repo market, and the liquidity premiums is of interest to market makers and portfolio managers who wish to know what systematic risk premiums they will receive for taking each type of factor risk. In particular, an arbitrageur would like to use the traded cash market and term repo markets to forecast the implied liquidity premiums of a group of bonds with similar term structure to buy the highest spread and sell the lowest spread to capture the liquidity premium difference between bonds that may result from temporary imbalances in supply and demand for certain issues.
This field of study also has implications for risk managers, policymakers, and regulators. Firms’ risk managers would like to know how much exposure their portfolios have to financing risk and liquidity risk. Policymakers that seek to stabilize market liquidity such as the Federal Reserve and the Department of Treasury would like to know which sectors of the collateral term structure market should be reopened. Regulators are concerned about which issues are special due to restrictions on collateral from institutional requirements, legal issues, or frictional costs.
Download
PDF Ebook Liquidity Risk, Special Repo Rates, and the Credit Crunch of 2007: An Emprical Analysis
Posted in :
