A quick guide to repurchase agreements, (repos)

What is a repurchase agreement, (Repo)?

A repo transaction involves two parties, the buyer and the seller. There are two exchanges that occur. One is at the start of the trade, the other is at maturity. At the start, the seller delivers collateral, normally bonds, to the buyer. In return the buyer simultaneously pays cash to the seller. That amount is equal to the market value of the collateral, this includes any accrued interest, (see diagram 1). On the maturity date the buyer returns the collateral to the seller. Simultaneously the seller repays the original cash amount to the buyer plus a sum of interest for being able to use the cash. The interest rate that is used is called the repo rate. The repo rate is normally calculated on a money market basis, actual/360, (see diagram 2). When dealers enter into a repo trade they agree the terms of the deal. These include the collateral involved, the maturity of the trade, (normally these trades are short term from 1 day to 3 months in maturity), the cash amount and the repo rate. During the life of the transaction the market risk and the credit risk of the collateral remain with the seller. (Because he has agreed to repurchase the asset for an agreed sum of money at maturity). Provided the trade is correctly documented if the collateral has a coupon payment during the life of the repo the buyer is obliged to pay this to the seller. During the life of the trade the buyer can use the collateral for delivery or repo purposes. And if the seller fails to return the cash the buyer can look to the collateral for repayment.

General & special collateral rates

The repo rate normally trades closely to money market rates. This is sometimes referred to as the general collateral rate. But sometimes a particular security is in demand for borrowing purposes. This is because there are many dealers who have gone short of that security. In this situation the cost of borrowing the security increases and depending on supply and demand conditions the repo rate can fall significantly. It can end up several percentage points beneath the prevailing money market rates. And in extreme situations a negative repo rate can occur. When the repo rate for a specific security falls like this the repo rate is called a special rate. Special repo rates mean that the individual security is expensive to borrow for dealers who are short. But for those who are long there is a windfall gain. They can borrow cash at rates well below money market rates and make a simple profit by redepositing it at the prevailing money market rates.

Haircuts
Haircuts are the repo markets way of imposing a margin on the collateral seller. Here is a simple example. Suppose a haircut of 2% is applied to a repo trade where the market value of the collateral is $10m. The seller only receives $9.8m from the buyer and the repo interest is calculated on $9.8m. Why do haircuts exist? Because some bonds are more risky than others. The buyer will look to the collateral for repayment should the seller default. If the collateral has a volatile price history the buyer is at risk. The collateral may fall in price at the very time it is being relied on. To reduce this risk a haircut is imposed.

Why do dealers do repo trades?

Simply because there is both the demand for borrowing the collateral and there is supply of that collateral. The motivations are as follows: When dealers want to take advantage of falling prices they sell something they dont have. They anticipate that they will buy it back at a later date for a lower price and make a profit. This is called going short. If you short sell you need to deliver the security you have sold to the buyer. But you dont have it! You therefore need to borrow it. This means becoming a buyer in a repo trade. (Technically this is called a reverse repo). The repo means you can temporarily borrow the security and use it to make delivery, (see diagram 3). If you are right and prices fall you can buy back the security at a lower price and deliver it to your repo counterparty on the maturity of the repo. You will have profited from the fall in the price of the collateral.

Buy/sell back transactions

Buy/sell back transactions are identical to repo transactions in terms of the collateral movements and cash flows. They differ in that the trade is structured as a spot purchase and a forward sale of the collateral. This means that instead of the transaction being based on an interest rate, (the repo rate), it is based on a spot price at which you buy the collateral and a forward price at which you sell the collateral.

Why would you want to lend the collateral?

When dealers or portfolio managers own bonds they can use them as collateral for borrowing cash, (like a secured loan). The repo rate may well be a few basis points lower than normal money market rates. Sometimes it is much lower. Repo can therefore be a useful tool for liquidity management.

William Webster Barbican Consulting Limited Financial Markets Training wwebster@barbicanconsulting.co.uk 00 44 (0)20 79209128

www.barbicanconsulting.co.uk Financial Markets Training

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Diagram 1 - start Trade details: Principal Bond price Repo principal Repo rate Term $10,000,000 100% $10,000,000 5.00% Actual/360 7 days

Collateral seller

Bonds

Collateral buyer

$10,000,000

Diagram 2 - maturity Trade details: Principal Bond price Repo principal Repo rate Repo interest $10,000,000 100% $10,000,000 5.00% Actual/360 $9,722.22

Collateral seller

Bonds $10,009,722.22

Collateral buyer

Diagram 3 Using a repo in a short sale Dealer sells bond & must deliver Dealer enters reverse repo to obtain bond for delivery To close the repo trade the dealer must eventually buy the bond in the market

Bond purchaser

Bond

Dealer sells bond

Bond Cash

Repo

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