A Framework for Collateral Risk Control Determination

This paper derives a general framework for collateral risk control determination in repurchase transactions. The objective is to treat consistently heterogeneous collateral so that the collateral taker has a similar risk exposure whatever the collateral pledged. The framework measures the level of risk with the probability of incurring a loss higher than a pre-specified level given two well known parameters used to manage the intrinsic risk of collateral: marking to market and haircuts. It allows for the analysis in a closed form of the way in which different relevant factors interact in the risk control of collateral (e.g. marking to market frequency, level of interest rate volatility, time to capture and liquidity risk, counterparty default probability, etc.). The framework, which combines the recent theoretical literature on credit and interest risk, provides an alternative quantifiable and objective approach to the existing more ad-hoc rule-based methods used in haircut determination