What s Repo

3. What�s Repo? A repurchase agreement, or repo, is a single transaction consisting of A spot portion in which a security is sold for cash and A forward portion in which the security is repurchased for later settlement Dealers often use repo to finance inventories of securities Repo can be for overnight, term or open

4. Repo: Spot Portion Investor

5. Repo: Forward Portion Investor

6. Repo Investor

7. Example

8. Terminology The party who sells collateral in the first leg and repurchases collateral in the second leg is called the repo seller. Dealers who finance securities with repo are repo sellers. The other party is the repo buyer. Investors who invest in repo are repo buyers.

9. Repo Mechanics Margin Margin is collateral in excess of the principal amount of the transaction Demanded to limit credit exposure Typically 1% to 3% (5% to 10% for riskier collateral) Example: If margin is 2%, a dealer would deliver $10.2 million (market value) of collateral against a principal amount of $10 million.

10. Example: T-bill Margin

11. Repo Mechanics Marking to Market Collateral may be marked to market and the trade adjusted Margin call: If collateral value declines, additional collateral may be required to restore the original margin. (Dealer delivers more collateral to investor.) Repricing: If collateral value declines, the principal amount of the transaction can be reduced to restore the original margin. (Dealer wires cash back to investor.)

12. Repo Mechanics Collateral Substitution Dealer may request the investor to return the original collateral in exchange for different collateral having the same market value If collateral cannot be substituted, it is special Cash flows The repo seller is entitled to receive any interest or principal payments off the collateral

13. Repo Mechanics Collateral Delivery Outright: Seller delivers the collateral to the buyer. Buyer returns the collateral at maturity. Safekeeping: Seller holds the collateral for the buyer. Also known as �letter� repo or �held in custody� repo. Third party: Seller delivers collateral to purchaser�s custodial account at seller�s clearing bank.

14. Reverse Repo A reverse is a repo viewed from the perspective of the counterparty lending cash There are two reasons for doing reverses: Investors seeking short-term relatively safe investments may invest in repo. Traders seeking to cover a short position in a security may borrow the needed securities by doing a reverse for specific collateral

15. Repo Rates General collateral rates Relation to the Fed funds rate Specials Rates can go special when there is strong demand for specific collateral Example: Traders as a group build up a sizeable short position in a particular issue.

16. Repo Books Dealers often work both sides of the market, doing repo with one group of investors and reverses with another. In a matched book, a dealer reverses in securities from one party, repos them out to another party, and profits from the spread.

17. For Example A Brazilian bank finances some of its Brazilian Brady holdings by doing a repo with a dealer in New York for LIBOR + 1% The repo dealer in New York uses the collateral to do a repo with an American investor for LIBOR The dealer pockets the spread (1%)

18. Application: Tailing If you buy a 90-day T-bill and hold it for 30 days, it becomes a 60-day bill.

19. Application: Tailing To create a T-bill �tail� Buy a T-bill with t1 days to maturity Finance it for t2 days with term repo Inherit a T-bill with t1 - t2 days to maturity when the financing comes off. Dealers use this strategy to buy T-bills forward Why buy bills forward?

20. For Example

21. Quick Check Explain the mechanics of a repo transaction. What is margin in the repo market? Why is it needed? How does it vary by collateral? How do repo rates go special? What�s a bill tail? How do dealers create them? Why?

22. Review Scope of the money market Three bases for measuring yield Effective yield and Bond Equivalent Yield Details of the T-bill market Mechanics of the RP market

25. What is a Bond? A bond is a debt contract between The issuer (borrower), and The purchaser (lender). Bond indentures Detailed description Cash flows Security interests Covenants Default provisions Role of trustee

26. Sellers and Buyers Bonds are issued by Sovereigns and other government agencies Corporations Bonds are purchased by Institutions Financial corporations Individual investors

27. Bond Characteristics Principal and coupon Corpus Coupons (frequency) Zeros Maturity Prepayment option Hybrids Convertibles

28. Bond Markets Primary Auction mechanisms Placed issues Private placements Public offerings Secondary Exchange traded OTC markets

29. Example The US government 8 3/4 of 5/15/20 Originally issued 5/15/90 as a 30-year bond Not callable Par bond (issued at par; redeemed at par) Pays 4.375% semi annually Traded OTC Recently quoted at 131:21 ask (5.98% ytm)

30. Example Kyushu Electric Power $40 billion yen issue of 10-yr bonds In Japan Denominations 1MM yen thru 100 MM yen Issue date 11/10/00; Maturity date 11/25/10 2.00% coupon payable semi annually Priced at 99.99 (2.001% ytm) Lead manager was Mizuho Securities

31. Example Mexican (Brady) Series A Par Bond Issued March 1990 Original issue maturity of 29 3/4 yrs 6 1/4% fixed coupon Principal (face amount) backed by US Government zeros Designed to replace defaulted loans Sold at well below face value initially Risky coupon

32. Bond Pricing The bond equation Equates a bond�s price to the discounted present value of the future cash flows associated with the bond