International Fixed Income The Repo Market International Fixed Income

Readings Repo’s gone global and hip Innovation is the key Merrill Lynch guide to international repo

Overview of this Lecture Agenda: I. Repo basics II. Features of the repo market

Section I Repo Basics

Repurchase Agreements Repurchase agreement (repo): a contract to sell a security and then repurchase it at a later date for a specified price. We can think of a repo as a collateralized loan, where the collateral is the security. This is because the seller of the security retains the right to receive any interest paid on the security over the term of the repo agreement. Repos are one of the largest sectors of the money market (approximately $1 trillion daily). The repo market provides attractive returns to money market investors, and an inexpensive source of financing for security holders.

Illustration A government securities dealer buys $25 million worth of the 6¾ T-notes of 8/15/2005 to hold overnight. Where does the dealer get the funds to finance his position? The dealer could use his own funds, borrow from a bank, etc... But the repo market is typically the cheapest source of financing. So, let’s assume the dealer uses the T-notes as collateral and enters into a repo.

Illustration continued... A customer of the dealer (e.g., some municipality with newly collected tax receipts) has $25 million it would like to invest overnight. The dealer sells the customer the T-notes for settlement today, and agrees to buy them back tomorrow for $25 million plus interest. The interest rate is called the repo rate. If the repo rate is 5½%, then the total interest paid is (5½%)(1/360)$25 million = $3819.44. 6

Illustration continued... The customer has, therefore, invested $25 million overnight at a 5½% rate. Credit risk aside, the customer does not care whether the price of the 6¾ T-notes goes up or down. The market risk is assumed by the dealer.

A Reverse Repo Now, suppose it’s the customer who owns $25 million worth of the 6¼ T-notes of 8/15/2005 and wants to borrow funds overnight. The dealer buys the T-notes for settlement today, and simultaneously agrees to sell them back to the customer tomorrow for $25 million plus interest in the amount of (5¾%)(1/360)$25 million = $3993.06. The result is that the customer has borrowed $25 million overnight at 5¾%.

Repo and Reverse Repo Jargon Repo (Dealer) Selling collateral Borrowing money Reversing out securities to repo securities Reverse Repo (Dealer) Buying collateral Lending money Reversing in securities to do repo Obviously, it is important to recognize that the dealer's repo is, from the standpoint of the customer, a reverse repo. We will always refer to the transaction from the dealer’s perspective.

A Repo Graphically Money lent REPO: Leg 1 Borrower of money Borrower (buyer) of collateral Securities (that is) Money + interest repaid REPO: Leg 2 (that is) Supplier (seller) of collateral Securities Lender of money

The Government Repo Market

Section II Features of the Repo Market

Dealers Dealers enter into repos for a variety of reasons Inventory: most dealers and traders do not own all the securities in their inventory outright, so the standard practice is to finance holdings by borrowing in the repo market. Short positions: dealers also use the repo market to cover short positions (i.e., they buy the securities to cover the short position and sell them back in a reverse repo). Matched books: dealers buy collateral from one customer (e.g., a thrift) and sell to another (e.g., a money market fund) at lower rate.

Terms of the Loan Overnight repos: one-day transactions Approximately 50% of the market. Open repo is an overnight repo that rolls over automatically. Term repos: transactions beyond one-day (up to one year). Vast majority of repos have maturities of three months or less.

Credit Risk Both parties are subject to credit risk The market value of the collateral can change, and one or both party's overall financial position may change for a variety of other reasons.

Illustration Suppose a school district enters into a $10 million 30-day repo with a dealer who is under-capitalized. The dealer delivers the $10 million in T-notes, but is forced into bankruptcy and cannot repurchase them. The school district can sell the collateral in the open market to get its money back. However, if the market price of the T-notes has fallen, then the district will suffer a loss.

Ways to Reduce Credit Risk Margin: Lenders often require margin to limit their credit exposure (typically 1% to 3%). Example: a customer enters a repo for $10 million with a 2% margin. The dealer delivers $10.2 million worth of securities, receives $10 million, and repurchases the securities on a future date for $10 million plus interest. Marking to market: Collateral is valued at current market levels and the trade is adjusted through a marginal call (dealer sends more collateral) or repricing (funds are delivered to customer).