Initial Margin/Haircut
In general, the start proceeds of a repo should be equal to the market value of the collateral. However, in certain cases, it is possible for the start proceeds to be different from the market value to reflect the price volatility of the collateral. The percentage difference between the market value of the collateral and the one used in calculating the start proceeds is referred to as the haircut or initial margin.
Initial margin/haircut usually protects the buyer against price volatility. This comes in different forms as depicted below:
- Liquidity of collateral
- Counterparty risk
- Default risk of collateral
- Other sources of volatility of value (eg, maturity)
- Currency risk
- Term of repo
- Lack of documentation
- Frequency of margin maintenance
- Regulatory requirements
- Country risk
Initial margin/haircut is unusual in inter-dealer transactions, very short term and brokered transactions, however common among the hedge fund industry.
