Liquidity risk and specialness

Repo contracts, the most important form of collateralized lending, are widely used by financial institutions and hedge funds to create short-selling positions and manage their leverage profile. Moreover, they have become the primary tool of money management and monetary control of several central banks, including the Bundesbank and the newly born European Central Bank. This paper is an empirical study of this market. More specifically, we study the extent to which the current term structure of long term "special" repo spreads discount the future collateral value (specialness) of Treasuries. We ask whether repo spreads embed a liquidity risk premium and whether such a risk premium is time-varying. We quantify the size of the average liquidity risk premium and we provide empirical evidence of the extent of its time-variation. (C) 2002 Elsevier Science B.V. All rights reserved.