Session 3 Repo and Reverse Repo Markets Chapter 5

1. Session 3 Repo and Reverse Repo Markets Chapter 5

2. What is a repo agreement? A repo agreement is a contract in which a security is pledged as collateral with an agreement on the initiation date to redeem the security at a higher price on a later date specified in the contract. In Figure 5.1, we illustrate a repo transaction. Institution X delivers a Treasury note with a market value of $1,000,000 to Institution Y, which delivers to Institution X $1,000,000 in cash (initial transaction, or the opening leg in the figure). For simplicity, we assume that the Treasury note is selling at par. On the same day, Institution X agrees to buy back from Institution Y the same security on the very next day (overnight) at a price of $1,000,138.89 (closing transaction, which occurs the next day).

3. Repo transactions

4. Repo transactions The price at which institution X agrees to buy back was arrive at as follows: The implies interest rate is 5%, and this is determined by the market forces.

5. What is a reverse repo agreement? A reverse repo agreement is a contract in which a security is borrowed with an agreement on the initiation date to replace the security at a higher price on a later date specified in the contract – flip side of a repo. Figure 5.2 illustrates a reverse repo transaction from the perspective of Institution X. Institution X borrows a Treasury note with a market value of $1,000,000 to Institution Y and delivers to Institution Y $1,000,000 cash (initial transaction in the figure). For simplicity, we assume that the Treasury note is selling at par. On the same day, Institution X agrees to sell back to Institution Y the same security on the very next day at a price of $1,000,138.89 (closing transaction, which occurs the next day).

6. 1. Initial Transaction in Reverse Repo Agreement Treasury Note Institution X Institution Y Cash $1,000,000 2. Closing Transaction in Reverse Repo Agreement Treasury Note Institution X Institution Y Cash $1,000,138.89

7. Size of repo and reverse repo markets Source: “Developments in repo markets during the financial turmoil,” by Peter Hördahl and Michael R King, Quarterly review, BIS, December 2008.

8. Repo transactions – underlying collateral

9. Example of repo transaction On August 31, 2007, the 30-year T-bond with a coupon of 5.00% and maturing on May 15, 2037, was quoted at a clean price of 102.50. The general collateral repo rate for a term of one month was 4.775%. A bond dealer receives an order from a client to buy this bond forward in one month’s time. What is the forward price that dealer should quote? Why? How should the dealer hedge the exposure, assuming that the deal is done on August 31, 2007?

10. Example of repo transaction The dealer will first compute the forward price as follows: • Borrow cash to buy the bond in the repo markets for a one-month term on August 31, 2007. 2. Figure out how much has to be paid in the repo markets on September 30, 2007, to retrieve the collateral. 3. This is the forward price at which the dealers will break even. Any additional profit margin would depend on the extent of competition.

11. Example of a Repo transaction

12. Example of a Repo transaction • Dealer A owns the security and gets the accrued interest. • Dealer A must pay B the repo interest on the cash borrowed. • In an upward sloping yield curve, dealer A enjoys a positive carry.

13. Example of a Repo transaction • Dealer B owns the security and gets the accrued interest. • Dealer B must pay A the repo interest on the cash collateral. • In an upward sloping yield curve, dealer A faces a negative carry.

14. General Collateral Repo Rates • In a general collateral repo contract, the lender of cash is willing to accept any security within a class of securities. • Sometimes such a contract is referred to as a GCrepocontract and the rate on that contract is referred to as the GC repo rate . • In a GC repo contract, the lender of cash (such as a mutual fund or fixed-income asset management firm) is primarily interested in earning interest income with limited counterparty credit risk. • As long as the class of securities specified in the GC repo contract can be quickly liquidated at a low transaction cost in the market without an adverse price reaction, the lender of cash is comfortable in entering into the GC repo contract.

15. GC repo rates tend to track Effective Fed funds rates

16. GC repo rates versus Effective Fed funds rates • There are important differences between the Fed funds rates • and the GC repo rates. • Fed fund rates apply to the market for reserves and therefore • to depository institutions, which are required to carry reserves. • GC repo rates apply to repo transactions, which are undertaken by • much broader set of participants, including depository institutions. • Fed funds rates apply to transactions that are not collateralized. • But as we have seen, repo rates apply to transactions that are • backed by a class of collateral. • There are important intraday and market microstructure situations • that cause Fed funds rates to fluctuate within each day. GC repo • rates may also reflect seasonal fluctuations on predictable days such • as quarter-ends and year-ends.

17. Special Repo Rates In a special collateral repo contract, the lender of funds specifies a particular security as the only acceptable collateral. Such contracts are referred to as special repo contracts and the interest rates on such contracts are referred to as special repo rates. The reason that such contracts might arise is best illustrated with a simple case: Consider a dealer who has a previously established short position in Treasury Note A. The dealer might want to cover his short position by delivering Treasury Note A. To do this, the dealer will lend cash against a specified Treasury Note A (specific security) and use the borrowed security to cover his previously established short position.

18. GC versus Special Repo Rates The special repo rate is typically lower than the GC repo rate in the same security class. In other words, the special rate on a 10-year Treasury note will be lower than the GC repo rate for Treasury securities as a class.

19. Fails in repo markets Fails occur in repo markets when a security is not delivered (as promised in the contract) on the contractual maturity date. When a fail occurs, counterparty credit exposure results. A very small number of fails occur due to miscommunications or improper and inaccurate documentation in the transactions. Fails can also occur because of an exogenous shock such as the September 11, 2001, attacks. These are idiosyncratic events. Fails that occur when a counterparty is unable to deliver a security may trigger a chain of failures. The level of the interest rates and the current market practice of dealing with fails that sets a floor of zero on the specials rate may also provide incentives for dealers to fail in repo transactions.

20. Fails in repo markets

21. Repurchase Agreement Rates Turn Negative as Fail Penalty Debuts Source: Bloomberg May 1, 2009 Rates in the $7 trillion-a-day market to borrow and lend government debt dipped below zero as a 3 percentage point penalty for failing to meet delivery obligations went into effect for the first time. The old five-year note, the 1.75 percent security maturing in March 2014, traded today at the lowest repurchase, or repo, rate, dipping as low as negative 1 percentage point. The rate closed at negative 0.05 percent, according to GovPX Inc., a unit of ICAP Plc, the world’s largest inter-dealer broker. A negative repo rate means that investors who lend cash in exchange for obtaining Treasuries as collateral actually pay interest instead of receiving it on the money they loan. “Repo rates went negative because we have the new fails fees,” said Joseph Abate, a money-market strategist in New York at Barclays Capital Inc., one of the 16 primary dealers that trade directly with the Federal Reserve.

22. Repurchase Agreement Rates Turn Negative as Fail Penalty Debuts Source: Bloomberg May 1, 2009 In a repurchase agreement, one party provides securities as collateral to another in exchange for cash; in a reverse repurchase agreement, the opposite takes place. When a security is not delivered as promised, the uncompleted trade is called a fail. The so-called general-collateral repo rate opened today on the bid side of the market, the price quoted for immediate sale, at 0.35 percent, according to GovPX. The federal funds rate opened at 0.21875 percent. The Fed’s official target rate for overnight loans between banks has been at a range of zero to 0.25 percent since December. Securities that can be borrowed in the repo market at interest rates close to the Fed’s target rate are called general collateral. Notes and bonds that are in the highest demand, such as the previously issued five-year note today, are called “special” by traders because rates on loans secured by these securities are lower than the general collateral rate.

23. Topic 3a - Conclusions/Main insights • Repo and reverse repo markets are used to finance securities and to earn interest on a collateralized basis. • These markets allow dealers and hedge funds to take significant leveraged positions with fairly low counterparty credit risk. • The Fed engages in repo and reverse repo with primary dealers to execute its open market mandate. • GC repo rates refer to collateralized borrowing/lending rates when a class of securities are accepted as collateral. • Special repo rates refer to collateralized borrowing/lending rates when only specified securities are accepted as collateral.

24. Topic 3a - Conclusions/Main insights (continued) • GC repo rates tend to track closely other short-term interest rates such as effective Fed funds rates, LIBOR and OIS rates. • There are important differences between these short-term interest rates. • Fails tend to occur when the GC repo rates are low. This incentive has since been addressed through a “fail penalty” of 300 basis points, allowing Special repo rates to go negative. • Forward prices on bonds can be arrived at using term repo rates.