Repos: Facilitating a dealer’s hunt for cash & securities

Nov 30 2012, 10:45 IST
Comments 0
SummaryThe term repo stands for ‘repurchase agreement’. Securities dealers carry large inventories of bonds for they need to stand ready to sell whenever an investor seeks to buy.

The term repo stands for ‘repurchase agreement’. Securities dealers carry large inventories of bonds for they need to stand ready to sell whenever an investor seeks to buy. Typically, the capital invested by the dealer in the business will be very small compared to the value of securities that he is carrying.

A dealer’s debt equity-ratio may be of a magnitude that is as high as something like 40:1. That is for every $41 worth of securities being carried by him, $40 is funded with borrowed money. Repurchase agreements facilitate the borrowing by dealers to fund their inventories.

A repurchase agreement is essentially a collateralised loan agreement. Take the case of a dealer who has securities worth $100 and seeks to borrow. He can enter into an agreement with a party willing to lend, whereby he agrees to sell the securities for $100 with a simultaneous agreement to repurchase it at a slightly higher price.

As can be seen, this is essentially a collateralised borrowing arrangement. The difference between the sale price and the purchase price constitutes interest income for the party who is offering to buy the securities.

The securities themselves constitute collateral, for if the dealer who borrows reneges on his commitment to buy them back, the lender can have them sold to recover the amount lent. In some cases the sale and purchase price for the securities will be identical and the interest will be separately calculated and paid.

In practice, a dealer who offers securities that are currently valued at $100, will not get a loan for the same amount. This is because the lender will seek to protect himself against a sharp decline in the value of the collateral and will consequently agree to lend a lower amount. If a lender were to lend $95 against an offer of securities that are currently valued at $100, we would say that he has applied a ‘haircut’ of 5%.

Sometimes, the asset being offered as collateral will pay a coupon during the period that it is with the lender. In such cases, the understanding is that the lender will collect and pass on the cash to the borrower.

This is because while there is a transfer of ownership legally, the borrower continues to be the beneficial owner of the securities.

Due to market fluctuations, the collateral value may increase or decrease. If it were to decline in value, the lender will ask for more collateral, whereas if it were to increase in value, the borrower can usually seek a partial return of securities. The valuation of the collateral at current market prices to determine whether additional collateral is required is referred to as ‘marking to market’.

In practice, both the lender and the borrower are vulnerable to default risk. If interest rates were to increase after the loan is made, the debt securities given as collateral would decline in value. In such cases, the lender faces the risk that the borrower may renege on his commitment to buy back the securities, thereby leaving the lender with assets which are worth less in value than the loan amount.

However interest rates can always fall, which would lead to an increase in the value of the collateral. In such a situation, the borrower faces the risk that the lender may refuse to return the collateral and is prepared to forfeit the loan amount, since, by assumption, he has assets that are worth more than the amount lent.

There is no strategy that will simultaneously reduce the risk for both parties. Lenders can be protected by applying a larger haircut. For instance, a lender may seek to lend only $90 against securities worth $100. Borrowers can be protected by applying what may be termed as a ‘reverse margin’. That is, a party may offer securities worth $100 in return for a loan of $110. Quite obviously, we cannot have haircuts or margins, and reverse margins, at the same time.

In practice, lenders apply haircuts, that is, they receive margins. The rationale is that the lender is offering cash in return for marketable securities, and since cash is always more liquid than any security, the system offers protection to the lender.

Every repo must be matched by a reverse repo. That is, the transaction as perceived from the borrower’s angle is termed as a repo, whereas the same transaction as perceived from the lender’s angle is known as a reverse repo. Thus, every repo must be matched by a reverse repo. A dealer who is hunting for cash to fund an acquisition of securities will undertake a repo.

On the other hand, if he is hunting for securities to undertake a short sale, he will do a reverse repo. This is because the short sale transaction will require him to acquire and sell the securities and will in the process generate cash, which can be invested.

A repurchase agreement is subject to standard industry documentation and both legs of the transaction together constitute a single contract. In India, such transactions are known as ‘Ready-Forward’ or RF contracts, since the first leg, whereby the borrower pledges and gets the cash, is a spot transaction, while the second leg, whereby he commits to return the cash in return for the securities, is essentially a forward contract.

The collateral for such transactions is typically a government security. However, in the US, other debt securities, such as commercial paper may be offered as collateral.

The writer is the author of ‘Fundamentals of Financial Instruments’, published by Wiley, India

Ads by Google

More from Personal Finance

Reader´s Comments
| Post a Comment
Please Wait while comments are loading...