DP13546 Repo rates and the collateral spread puzzle

Author(s): Kjell G Nyborg
Publication Date: February 2019
Keyword(s): collateral spread, constrained-arbitrage, general collateral, liquidity, market linkages, repo rate, unsecured rate
JEL(s): G01, G12, G21
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13546

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.