Working Paper: CEPR ID: DP13546
Authors: Kjell G. Nyborg
Abstract: Repo rates frequently exceed unsecured rates in practice. As an explanation, this paper derives a constrained-arbitrage relation between the unsecured rate, the repo rate, and the illiquidity adjusted expected rate of return of the underlying collateral. The theory is based on unsecured borrowing constraints in the market for liquidity. Repos and security cash-market trades are alternative means to get liquidity. Collateral spreads (unsecured less repo rate) can turn negative if borrowing constraints tighten, unsecured rates spike down, or from a depressed and illiquid security market. The constrained-arbitrage theory sheds light on the evolution of collateral spreads over time.
Keywords: collateral spread; constrained-arbitrage; liquidity; market linkages; repo rate; unsecured rate; general collateral
JEL Codes: G01; G12; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| borrowing constraints in the unsecured market tighten (G21) | spike in unsecured rates (E43) |
| spike in unsecured rates (E43) | behavior of repo rates (E43) |
| tightening borrowing constraints in the unsecured market (G21) | negative collateral spreads (G19) |
| repo rates exceed unsecured rates (E43) | liquidity in the security cash market is under stress (E44) |
| collateral spread (F65) | moves in the same direction as unsecured rates (E43) |
| higher haircuts and volatility in the underlying security market (G13) | increase in collateral spread (F65) |