# Repo Market

I’m trying to understand how to calculate carry (yield) on a repo transaction. I would appreciate if people let me know if my understanding of reverse repo and repo is sound or not based on the two examples below and answer some of the questions found below. Thank you. For example, our firm’s hedge fund is long this Argentina bond that is currently trading special in the repo market. Our firm is taking advantage of this situation by lending (selling) the security to a dealer (who probably needs to cover his short) in exchange for cash at rate of 2.75%. In other words, we pay the dealer 2.75% for cash, which we can invest at a General Collateral rate (which is greater than special rate), which we can say is currently 4.75%. We can therefore say that this repo market transaction has a carry (yield) of 2% (4.75% - 2.75%). Our firm booked this trade as a “reverse repo.” Can someone explain to me why this is a reverse repo and not a repo from our firm’s perspective? Or do you think maybe our firm is booking repo market trades from the dealer’s perspective? If our hedge fund wants to do a pairs trade for example, where we buy one bond and short-sell another bond we utilize the repo market for the short-sell side of the trade. We book this trade as a “repo.” If our firm does indeed book repo market trades from the dealer’s perspective, can someone explain to me how our firm’s role in this transaction is identical to the dealer’s role in the above “reverse repo” transaction since repo/reverse repo terms are simply from the other party’s perspective? I’m a bit fuzzy here in trying to find a connection. The way I view a short-sale transaction is: My firm calls up dealer and tells him they want to short-sell bond A. The dealer looks for a client who is long bond A. The dealer borrows Bond A and charges my firm 5% interest. Dealer gives my firm bond A at which point my firm sells the bond and gives the cash proceeds to the dealer. The dealer invests the cash at LIBOR and let’s say that my firm is entitled to the entire interest earned on the cash. Let’s say LIBOR is 4.75%. Therefore, my firm’s repo carry (yield) on this repo market transaction is -0.25% (4.75% - 5.00%).

y shud the dealer charge u 5% interest when ur the one who is lending the cash in exchange for a bond???..u shud be earning the interest on ur cash…though the interest rate u earn wud be lower considering its a secured loan.

Your firm is simply booking trades from the perspective of the bond dealer, which would be consistent with the Federal Reserve’s policy (so not very unusual). In the first case, you are providing a bond to the dealer so you can borrow money cheap (did you happen to own those bonds or you just went out and bought them to “take advantage of special repo” ?). In the second case, the bond dealer is providing the bond to you so that you can short it.

I never really understood the purpose of a repo. I can see that getting cash by lending a bond overnight might help if you are doing day trading in as +/- 12 hour time zone, but if you are pretty much bound to return the bond the next morning or have your credibility trashed, how does one benefit by getting into this deal. I can understand the bond lender, who might get an extra basis point or two of return by lending it out, but the risk sounds a bit like writing calls. You get a little extra premium until *bam* your bond disappears one day. What am I missing here?

I am by no means any bond expert but the purpose of a repo is to borrow at a lower interest rate than you could without collateral. If you need cash (for trading or for making some margin trading or other) you could borrow funds from somebody and at the same time put your bond as collateral. This gives you a much better borrowing rate than otherwise. From the lenders perspective, he has excess cash short-term (or is trading spreads) so he wants to lend this cash to somebody to earn the interest. It is way to much risk to lend it without any collateral so he want a bond as collateral to lend you money, at the same time he can of course not charge you the same high interest rates as without collateral. I don’t really see how your bond disappear one day?

> I don’t really see how your bond disappear one day? You lend to someone overnight and collect some extra interest on it. One day, the person you lend it to does something crazy and is for some reason unable to return your bond to you. They default. The idea of using your bond as collateral to reduce borrowing costs makes sense to me… but do you need to do a repo for that? If you don’t make your payments, they keep the bond, but why would you need to lend and reposess overnight for that? Just because it’s more secure than if you promise the bond as collateral normally? Any other reasons for doing a repo?

Think of a repo as a collateralized loan. You aren’t lending your bond, your posting it as collateral to secure a cash loan (selling collateral is another way to put it). If the party you “sold” the bond to defaults, so what you’ve got the cash. The credit risk is to the other party, that the borrower of cash defaults and the value of the bond you’re holding as collateral declines below the value of the loan. Collateral haircuts limit but don’t eliminate this risk. Repo markets are absolutely essential to the financial system. Securities dealers use them to fund a large chunk of their inventory. The collateral changes hands (or stays with an agent in an arrangement called tri-party) to further lower the credit risk in the event of default. Also be aware that you can use a repo to finance the purchase of the bond you are posting as collateral, so you can think of it as the cheapest way to buy a bond on margin. The only out-of-pocket expense is the haircut. Also repos don’t have to be overnight, there is an active term repo market.

lend and reposess overnight increase liquidity, the cash lender can get his cash back in a snap of finger if he wishes by stop rolling the repo.

If you counterparty fails to return your bond, you simply don’t return his cash. Using a daily mark-to-market on your collateral and margin calls also limit you counterparty risk. But repo’s are a great way to raise cheap cash, or invest cash if you’re worried about counterparty exposure.