LO 51.3: Explain how counterparty risk and liquidity risk can arise through the

LO 51.3: Explain how counterparty risk and liquidity risk can arise through the use of repo transactions.
Repo transactions involve the exchange of cash as well as the exchange of collateral. As a result, both counterparty risk (credit risk) and liquidity risk are present.
Counterparty risk is the risk of borrower default or non-payment of its obligations, and it arises because the lender is exposed to the risk of a failure by the borrower to repay the repo loan and interest. Given, however, that repo loans are secured by collateral, this makes the lender much less vulnerable to a decline in the creditworthiness of the borrower. The lender can recover any amounts owed by simply selling the collateral. As a result, because repos are generally very short-term transactions secured by collateral, counterparty (credit) risk is less of a concern.
Liquidity risk is the risk of an adverse change in the value of the collateral and can be of particular concern to the lender. Even if the lender is less concerned with the credit risk of a counterparty given the security of collateral, the lender is still exposed to the risk of collateral illiquidity and to the value of the collateral declining during the repo term. Especially during times of market turbulence (as we will see in next LO), the value of
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
collateral can decline significantly and its liquidity can dry up. This risk can be mitigated with the use of haircuts, margin calls, reducing the term of the repo, and accepting only higher quality collateral.
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