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Repo Rates and the Collateral Spread Puzzle: Theory and Evidence

□ Published by Kjell G. Nyborg and Cornelia Rosler

□ Published on October 2018

□ Summary of the article:

The collateral spread is the unsecured rate less the repo rate. The puzzle is that this is frequently negative. To understand this, we develop a theory where repos are motivated by the need to raise liquidity. The unsecured and the security cash markets are alternative sources. Unsecured borrowing constraints generate a constrained-arbitrage relation between the repo rate, the (adjusted) expected rate of return of the underlying security, and the unsecured rate. Collateral spreads can turn negative if borrowing constraints tighten, unsecured rates spike down, or from depressed and illiquid securities markets. Collateral spreads increase in haircuts and decrease in the volatility, illiquidity, and expected rate of return of the underlying collateral. Empirical tests using comprehensive data from Eurex
Repo are supportive. We use the theory to provide a narrative of the evolution of collateral spreads from before to after the financial crisis.

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