In a repurchase agreement (or repo) the borrower sells securities and promises to buy them back at a fixed price and date. Suppose two parties enter into a repurchase agreement for 7 days in which the repo rate is 1.25%. The securities in question (assume they are commercial paper) have a current market value of $30M and a 2% haircut is applied so that the amount borrowed is $29.4M.

a. (3 points) What purpose does the haircut serve in this transaction?

b. (2 points) How much is the borrower able to borrow if the haircut rises to 5%.