SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS

SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS

There are special borrowing arrangements for financial institutions such as commercial banks and securities firms in which the securities (partic- ularly, bonds) that they own or want to acquire are used as collateral. The arrangement is called a repurchase agreement.

A repurchase agreement, commonly referred to as a repo, is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. The price at which the seller must subsequently repurchase the security is called the repurchase price and the date that the security must be repur- chased is called the repurchase date. Basically, a repurchase agreement is

a collateralized loan, where the collateral is the security that is sold and subsequently repurchased. The term of the loan and the interest rate that the securities firm agrees to pay are specified. The interest rate is called the repo rate. When the term of the loan is one day, it is called an over- night repo; a loan for more than one day is called a term repo.

The transaction is referred to as a repurchase agreement because it calls for the sale of the security and its repurchase at a future date. Both the sale price and the purchase price are specified in the agreement. The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan.

The following illustration describes the mechanics of a repo. Sup- pose a securities firm wants to purchase for 10 days $10 million of a particular Treasury security using a repo to finance the purchase. Sup- pose further that a customer of the securities firm has excess funds of $10 million to invest for 10 days. (The customer might be a municipal- ity with tax receipts that it has just collected, and no immediate need to disburse the funds, or a mutual fund with cash it wants to invest for 10 days.) The securities firm would agree to deliver (“sell”) $10 million of the Treasury security to the customer for an amount determined by the repo rate and buy in 10 days (“repurchase”) the same Treasury security from the customer for $10 million the next day. Suppose that the over-

MANAGING WORKING CAPITAL

night repo rate is 3%. Then, as will be explained below, the securities firm would agree to deliver the Treasury securities for $9,991,667 and repurchase the same securities in 10 days for $10 million. The $8,333 difference between the “sale” price of $9,991,667 and the repurchase price of $10 million is the dollar interest on the financing.

The following formula is used to calculate the dollar interest on a repo transaction:

Dollar interest = (Dollar principal) × (Repo rate) × (Repo term/360)

Notice that the interest is computed on a 360-day basis. In our example, at a repo rate of 3% and a repo term of 10 days, the dollar interest is $8,333 as shown below:

The advantage to financial institutions of using the repo market for borrowing on a short-term basis is that the rate is lower than the cost of bank financing. The reason for this is that the borrowing is secured by the collateral and if the market value of the security declines, the securi- ties firm would be required to put up more collateral or return cash.

Four final points about repos. First, there is not one repo rate. The rate varies from transaction to transaction. One factor that affects the repo rate is the term of the borrowing. As explained in Chapter 3, there is a term structure of interest rates. The same is true in the repo market.

Second, in practice the amount loaned will not be equal to the mar- ket value of the securities. Instead, less will be loaned. By doing so, the lender reduces credit risk because the loan is overcollateralized (i.e., the amount lent is less than the market value). The difference between the market value of the security and the amount loaned is called the haircut.

Third, one can be confused by whether a repurchase agreement is a financing arrangement or an investment vehicle if one does not under- stand which side of the transaction a party is on. For example, in our illustration we demonstrated how a financial institution can use a repo to finance the purchase of a security. From the perspective of the cus- tomer that loaned the funds, the transaction is a short-term investment. Consequently, repos are referred to as money market instruments because they have a maturity of less than one year.

Finally, some financial institutions earn income by borrowing and lend- ing the same security in a repo transaction with the same maturity. This is referred to as running a “matched book.” For example, suppose that a secu- rities firm enters into a term repo of 10 days with a mutual fund and lends funds to a commercial bank for 10 days using a term repo. The securities

Management of Short-Term Financing

involved in both transactions are the same. If the repo rate on the repo trans- action with the mutual fund is 3.30% and the repo rate on the repo transaction with the commercial bank is 3.25%, then the financial institu- tion is earning a spread of 0.05% (5 basis points).