collateral, whereas if it were to increase in value, the borrower can usually seek a partial return of securities. The valuation of the collateral at current market prices to determine whether additional collateral is required is referred to as ‘marking to market’.
In practice, both the lender and the borrower are vulnerable to default risk. If interest rates were to increase after the loan is made, the debt securities given as collateral would decline in value. In such cases, the lender faces the risk that the borrower may renege on his commitment to buy back the securities, thereby leaving the lender with assets which are worth less in value than the loan amount.
However interest rates can always fall, which would lead to an increase in the value of the collateral. In such a situation, the borrower faces the risk that the lender may refuse to return the collateral and is prepared to forfeit the loan amount, since, by assumption, he has assets that are worth more than the amount lent.
There is no strategy that will simultaneously reduce the risk for both parties. Lenders can be protected by applying a larger haircut. For instance, a lender may seek to lend only $90 against securities worth $100. Borrowers can be protected by applying what may be termed as a ‘reverse margin’. That is, a party may offer securities worth $100 in return for a loan of $110. Quite obviously, we cannot have haircuts or margins, and reverse margins, at the same time.
In practice, lenders apply haircuts, that is, they receive margins. The rationale is that the lender is offering cash in return for marketable securities, and since cash is always more liquid than any security, the system offers protection to the lender.
Every repo must be matched by a reverse repo. That is, the transaction as perceived from the borrower’s angle is termed as a repo, whereas the same transaction as perceived from the lender’s angle is known as a reverse repo. Thus, every repo must be matched by a reverse repo. A dealer who is hunting for cash to fund an acquisition of securities will undertake a repo.
On the other hand, if he is hunting for securities to undertake a short sale, he will do a reverse repo. This is because the short sale transaction will require him to acquire and sell the securities and will in the process generate cash, which