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.
“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” ?).” Thanks Joey. We just happened to own the bonds and realized they were trading special so we took advantage of it. " In the second case, the bond dealer is providing the bond to you so that you can short it." Ok. So in this second case, my firm is lending the dealer money in exchange for a bond (aka collateralized loan) But my confusion lies in that where is the cost of this transaction to my firm? Does my firm need to have the cash for the bond prior to the transaction? Or can my firm have no cash, receive the bond from dealer, sell (short) the bond, give the cash proceeds to dealer, and earn interest on the cash albeit at a lower rate than cash b/c the dealer gave my firm the bond? If my firm has the cash for the bond, it can lend the cash to the dealer and earn interest lower than cash rate, AND they can (I think) sell (short) the bond that the dealer gave as collateral and invest the those cash proceeds at cash rate (GC). If my firm doesn’t have the cash for the bond before they sell (short) the bond, then they just earn interest lower than cash rate on the cash proceeds that they give the dealer from the short sale. In both of these cases, it seems, my firm is getting a free lunch because they are earning interest on cash that they wouldn’t be earning if they didn’t enter this repo transaction. Is the cost for my firm simply the coupon payment/accrual that they are responsible for paying to the bond lender? Additionally, all else equal, ideally a short seller would want to short sell a bond that is trading at a premium and the term structure of interest rates is inverted so he benefits from a positive rolldown (in this case roll-up) effect? Thank you all for your comments.
There is no free lunch here (as you seem to pretty much understand yourself). If you have cash on hand, then you hand it over to the bond dealer who gives you the bond and a repo contract that ensures you the repo interest rate on your money. As you point out, this is not a great interest rate but it’s a secure loan with miniscule risk (a bond dealer defaulting and the price of the bond plummeting to cause you significant losses would be bizarre). Now you sell the bond that you have promised to give back and earn short term interest on the money from the sale. In a normal world you would expect the longer term bond to be accruing interest at a faster rate than you can get in short term paper so when you buy it back, you expect that it will have accrued more interest than you earned in your short term deposits. Of course, you are betting that the price will go down because interest rates have gone up or some other bad thing has happened to the bond. As you say, if interest rates are inverted you get positive carry on the trade. You are essentially borrowing long-term money and lending short-term to take advantage of the inverted curve. This is just the mirror of the much more usual borrow short/lend long time-honored way of making money except that you are doing it in the unusual inverted curve siituation. If the curve gets more inverted or interest rates go down, you are SOL.
To add to Big Nodge’s comments - not only are they essential to bond dealers, but in the US, Fed open market operations are done mostly in the repo market. That means there is big liquidity there and it is the basis for day-to-day money supply adjustments.
“To add to Big Nodge’s comments - not only are they essential to bond dealers, but in the US, Fed open market operations are done mostly in the repo market. That means there is big liquidity there and it is the basis for day-to-day money supply adjustments.” Thanks Joey. On the topic of the Fed, I don’t know if you’ve been following the announced TAF auction the Fed announced in their aim to restore liquidity, but why does the market (media) always say that the Fed is injecting liquidity into the system by $X amount? For example, the headline of this week was that the Fed was going to increase liquidity in the system by increasing the sizes of the upcoming TAF auctions, but when I’m looking at the schedule of TOMOs outstanding, I see that the same amount of TOMOs (or more) are maturing on the day(s) of the TAF auction(s); therefore, the media’s claim that the Fed is injecting liquidity into the system is a bunch of crock, no? Is this simply a facade aimed at preventing a major panic-sell-off in the markets where market participants are under this illusion that the Fed is working “overtime” to fix things in the markets and participants take comfort in that for the time being?
Well, I haven’t been following this too closely (I just rolled my eyes when I heard about it then tried to forget it which you so rudely interrupted). TAFs and TOMOs have different participants, collateral requirements, and goals. Just to get everyone up to speed - TOMOs are the usual open market operations (the T is for temporary, but as far as I know, there are no POMO’s so I don’t know what it’s for. Maybe OMO sounds too much like a slur about someone’s sexual orientation). TAF’s are these new facilities for banks. The TAF program essentially amounts to having auctions for funds borrowed as if they were borrowed at the discount window. The auction process nearly guarantees that TAF borrowing costs something like Fed Funds borrowing but you can do it when Fed Funds liquiidity dries up. The reason I rolled my eyes at the program is that the Fed is taking a wide range of collateral for TAF borrowing that may be suspect and hard to value. That means the Fed is taking on risk that other banks would not be willing to take and for less money. That means that they are going to send me the bill someday. Anyway, TOMO’s are supposed to be about controlling the Fed Funds rate which is supposed to be the key rate for controlling inflation and keeping the money supply where the omniscient Fed wants it. They are conducted with 22 primary dealers for a much more restricted collateral than TAF’s. I guess a TAF loan has the same effect on the money supply as a TOMO “loan” (but I’m open to hearing why that’s not true) but AFAIK TAF’s are not supposed to be about targeting the Fed Funds rate. When the Fed injects money into the system through a TAF it is trying to shore up banks so they can easily get liquidity when the interbank market dries up. I cynically think it’s also about things like protecting the FHLB’s and propping up valuations on securities that nobody really wants but if you can use them as collateral at the Fed at least they are good for something so you don’t have to try to sell them to get liquidity. If it really does hit the fan and the TAF collateral turns out to be garbage, we’re all paying for TAF loans that will end up funding neo-Charles Keating’s.