Risk Involved
Although repo transactions are collateralized, there are a few risk parameters that anybody entering into repo should understand. We briefly describe these below.
Counterparty Risk
Participants of repos are exposed to counterparty risk in the event of a counterparty default. Repo documentation is designed to protect the participants against such situations. Before conducting any repo transaction, participants should conduct formal credit evaluations. In the event of counterparty default, participants will be collateralized by securities or cash.
Collateral Risk
Collateral risk is the risk the buyer faces in the event of default of the security being held. Depending on the repo agreements executed, the collateral can be returned to the seller for an early close-out of the trade or the seller can offer a substitute security of equivalent credit quality.
Therefore, in a way, a repo transaction offers double indemnity. If a repo counterparty fails, the other counterparty simply sells the pledged collateral to recoup the cash lost. If the collateral defaults then the counterparty lending collateral is called upon to provide margin. Risk of failure of collateral and counterparty at the same time is much lower than the risk of failure of collateral or counterparty.
Collateral Price Age
Assets held as collateral need to be re-priced in order to determine any over or undervaluation which may lead to margin calls. In some cases, obtaining a fresh price can be difficult for illiquid or structured products. This may lead to old or stale prices used for revaluation and hence price age risk, ie, incorrect valuation.
Settlement Risk
The settlement risk is the risk both counterparties are exposed to on the settlement date as collateral and cash move in different directions. Settlement risk has been reduced through STP (Straight-through-processing) as all matching of trades is now done automatically and
DVP. See Settlement Procedures for more information.
Interest Rate Risk
Repo and buy/sell back transactions involve cash flows and any such cash flow has inherent interest rate risk. The cash flow is determined by the net cash value of the collateral given, hence the collateralized loan feature of repo. Although repos can substitute this cash flow for another collateral, thereby constructing an asset swap, the usual asset flow is cash as repo is most often used for the benefits of the cash component. Therefore, any term repo or buy/sell back that involves a real cash flow have a related interest rate risk, which may require hedging. Compare that to securities lending, where the only real cash flow will be the fee paid/received.
