HOFIS 58 - Financing Positions in the Bond Market

Question 1

Repurchase Agreement (repo)

Answer 1

A contract where you sell a security to a party, and agree to buy it back at a future date

• Repurchase price: prices at which the security is bought back (typically greater than selling price)
• Repo rate: interest rate behind this loan (in comparison to collateralized loan)
• Trader selling the security to the repo deal, is borrowing cash (sale price) in exchange for using security as colleteral

Question 2

Reverse Repo

Answer 2

Opposite transaction to repo, where you purchase the security for cash, and agree to sell it back to the owner at a higher price in the future.

Question 3

Define the term haircut, in the context of a repurchase agreement, and its purpose

Answer 3

• The amount by which the market value of the security exceeds the value of the loan. Also called margin
• Reduce credit risk exposure by providing the lender a cushion in case the market value of the security declines

Question 4

Explain another ways to reduce credit risk of a repo

Answer 4

• Applying a haircut to the collateral
• mark-to-market the collateral on a regula basis
  
  • Collateral MV decreases –> borrower has to cure margin deficit by:
    
    • Providing additional cash to margin account
    • Transfering additional securities to lender

Question 5

Describe advantage of repurchase agreements from borrower’s side

Answer 5

Repo rate is typically pretty low and less than other costs of financing (i.e. LIBOR)

• due to the collateralization of repos

Question 6

Describe advantage of repurchase agreements from lender’s side

Answer 6

Offers an attractive yield on a short-term transaction that is secured (underlying collateral) and is highly liquid

Question 7

Repo interest formula

Answer 7

Question 8

Repo Return on Capital (from borrower perspective)

Answer 8

Question 9

Definition of Dollar Roll and compare to Repo

Answer 9

Dollar rolls are collateralized loans used in the MBS market that are similar to a repo agreement but have the following differences:

• Party who borrows securities does not need to return identical securities at the repurchase date
  
  • Returned security just needs to match coupon rate and security type
• Security borrower will keep the coupon and principal payments made by the security

Question 10

Why is the financing of Dollar Roll cheaper than Repo

Answer 10

Because of the flexibility to return a security that only needs to match the borrowed security on coupon rate and security type

Question 11

Describe a few elements to consider when determining the financing cost of a dollar roll

Answer 11

1. Difference b/w initial sale price and repurchase price (called the drop)
   
   • Repurchase price may be less than purchage price
2. Amount of scheduled principal payments and projected prepayements of the security sold
3. Attributes of the substantially identical security that is returned by the borrower

Question 12

How does amount of scheduled principal payments and projected prepayments impact Dollar Roll financing cost?

Answer 12

• A gain is realized by security borrower on any principal repayments if the security is purchased at discount (loss for security lender)
• A loss is realized if security purchased at premium (gain for security lender)

Question 13

Total financing cost and rate for the dollar roll from security lender perspective

Answer 13

Total financing cost = Lost coupon interest - Drop - Gain from principal payments

Financing Rate = Total financing cost/ Initial Security Price

Question 14

A risk to consider in determining Financing Cost of Dollar Roll

Answer 14

Prepayments make the principal that will be paid unknown

Question 15

Describe the features of a security lending transaction

Answer 15

In a security lending transaction, one party (the security lender) lends a security to the second party (the security borrower)

• The security borrower agrees to return the identical security to the security lender at some time in the future
• The security lender will also pay the security borrower a rebate at the end of the contract
• The borrower needs to pay the lender any interest or dividend payments made by the security
• Economically, a securities lending contract is very similar to a repurchas agreement
• Securities lending is important to short selling, in which an investor borrows securities to immediately sell them

Question 16

Credit Risk Metigation for Security Lending

Answer 16

To protect against credit risk, the security lender will require that the borrower provide collateral (typically cash)

Question 17

Security Lending Fee

Answer 17

Difference between the income earned from reinvesting the cash collateral and the rebate the lender will pay the borrower

• If the amount earned on reinvesting cash collateral is less than the rebate, then the security lender incurs a cost

Question 18

Compare Security Lending Rebate and Repo Rate

Answer 18

Rebate equivalent economically to repo rate

Question 19

Margin Buying

Answer 19

A standard margin agreement with a brokerage firm entails the following:

• The investor will borrow cash to buy securities, and use the securities as collateral
• Investor will receive a margin call to put up additional cash if margin account falls below min maintenance margin

Question 20

Margin Buying Maintenance Margin Requirement

Answer 20

Minimum amount of equity needed in the investor’s margin account compared with the total market value