Midterm Flashcards
If the value of the collateral decreases by 2% during the term of the repo, how
does this impact the money market fund? Discuss the potential actions by both
the lender and borrower
Since the collateral value falls below the loan amount, the lender may issue a margin call requiring additional collateral or repayment to maintain the loan to collateral ratio.
Definition of Repo
A repo (repurchase agreement) is a short-term borrowing mechanism where a party sells securities (such as government bonds) to another party and agrees to repurchase them at a later date, typically at a higher price. The difference between the sale price and the repurchase price reflects the repo rate, which is the cost of borrowing.
Borrower’s Perspective: The seller (borrower) receives cash in exchange for the securities, using the repo as a form of a secured loan with the securities acting as collateral.
Lender’s Perspective: The buyer (lender) provides cash and temporarily holds the securities. The lender earns interest through the difference between the sale and repurchase prices.
Collateral and Haircut: The securities provided act as collateral. To protect against a decline in the collateral’s value, a haircut may be applied, which is the difference between the market value of the collateral and the cash provided. For example, if the securities are worth $100 and the haircut is 2%, the lender would provide $98 in cash, ensuring protection against potential price drops.
Collateral and Counterparty Risk:
Repos are collateralized loans where the lender has the security as
protection against default.
* Counterparty risk arises if the borrower fails to repurchase the collateral at maturity
Repo Rate:
The interest rate on a repo transaction is known as the repo rate, which is effectively the cost of borrowing for the party selling the securities and borrowing cash
Haircuts/Margins:
In a repo transaction, the lender often applies a haircut or initial margin, which is the difference between the market value of the collateral and the amount of the loan. This reduces the lender’s risk in case the value of the collateral declines.
Types of Repos:
Overnight Repo
- A repo that matures the next day.
Term Repo
- A repo with a fixed maturity longer than overnight
Open Repo
- A repo with no set maturity date that can be terminated
by either party at any time.
Variation Margin Calculation
Step 1: Mark-to-Market – Regularly update the market value of the
collateral.
* Step 2: Net Exposure – Calculate the difference between the current
repurchase price and the updated market value of the collateral:
Net Exposure = Repurchase Price − Market Value of Collateral
* Step 3: Threshold – Only if the exposure exceeds a pre-agreed minimum
transfer amount or margin threshold, the variation margin is adjusted.
* Step 4: Adjusting Collateral – - If the collateral value decreases, post
additional collateral:
Example: Suppose a repo agreement involves a loan of $10 million with a
5% margin requirement. The initial collateral value is:
Required Collateral = 10, 000, 000
1 − 0.05
=
10, 000, 000
0.95
= 10, 526, 316
If the collateral value drops to $9.8 million, the borrower must post:
Net Exposure = 10, 000, 000 − 9, 800, 000 = 200, 000
The borrower must post an additional $200,000.
If the collateral value increases to $10.8 million, the borrower can withdraw:
Excess Collateral = 10, 800, 000 − 10, 526, 316 = 273, 684
Understanding Interest Rate Risk
Repos are short-term financing
tools, so fluctuations in interest rates, especially in longer-term repos, can
impact the cost of borrowing
Importance of Collateral Quality
The quality of collateral directly
affects the repo rate and the risk borne by the lender. Government securities usually receive a lower repo rate due to their low risk
Use of Repos in Monetary Policy
Central banks use repos to control
short-term interest rates. In an expansionary policy, central banks conduct
repos to inject liquidity into the financial system
Repo Market Liquidity
Repos help maintain liquidity in the financial markets by allowing institutions to borrow against their securities,
providing a source of short-term funding
Yield curve
x axis: Maturity
Y axis: interest rate/yield
Normally upward sloping, i.e. Long term yields are higher than short term yields
Liquidity premium theory
- What does it mean
- What types of risk captured
Liquidity Premium Theory integrates or expectations about future interest rates and their preference for shorter-term bonds by adding a positive premium for holding longer-term bonds, resulting in generally upward-sloping yield curves.
This theory extends the Expectations Hypothesis by adding a liquidity premium for long-term bonds. Investors typically prefer short-term bonds due to lower risk, so long-term bonds must offer higher yields to compensate for the extra risk.
The liquidity premium theory explains why longer-term bonds often have higher yields (an upward-sloping yield curve) and accounts for both interest rate expectations and risk premiums.
It captures interest rate risk and liquidity risk. Long-term bonds are more sensitive to changes in interest rates and are generally less liquid, meaning they are harder to sell without impacting the price.
Expectations hypothesis
Expectations Hypothesis suggests that the yield on a long-term bond is an average of current and expected future short-term interest rates, with no additional premium for holding the bond for a longer period.
SCENARIO A- Questions 9 & 10 are based on this scenario “This contract is a 30-day repurchase agreement on $100 of bonds at a rate of 2% with a haircut of 1%. In this scenario, the cash borrower (a hedge fund) engages in a “repo” and the cash lender (an MMF) engages in a “reverse repo.” This transaction is intermediated through a broker-dealer. According to data from the New York Fed, the median tri-party UST haircut is currently around 1%.”
Draw the schematic for the cash flow streams of the above repo scenario.
In March of 2020, Argentina’s risk spread increased to levels not seen
since 2005 as the coronavirus expanded globally. Why would the global
pandemic be accompanied by an increase in the risk spread?
When the pandemic started, governments advised citizens to isolate to slow the spread of the disease that had no cure or vaccine. This slowed economic activity worldwide. The increase in the risk spread in Argentina is just one example of changes that were occurring worldwide. When the overall growth rate of the economy slows or turns negative, it strains private businesses, increasing the risk that corporations will be unable to meet their financial obligations. The immediate impact of an impending recession, then, is to raise the risk premium on privately issued bonds. The economic slowdown doesn’t affect the risk of holding U.S. government bonds, though, so the spread increases.
Inverted Yield Curve
An inverted yield curve occurs when the yields on long-term bonds are lower than the yields on short-term bonds. According to the Liquidity Premium Theory of term structure, the yield curve reflects both investors’ expectations of future interest rates and a liquidity premium that compensates investors for holding longer-term bonds, which are generally considered riskier due to interest rate fluctuations. In a normal yield curve, longer-term bonds usually have higher yields due to this premium. However, an inverted yield curve suggests that investors expect future short-term rates to fall, possibly due to an impending economic downturn or recession
What does inverted Yield Curve signal
An inverted yield curve signals that the market expects short-term interest rates to fall in the future, often indicating an impending economic slowdown or recession. This inversion happens because investors believe the Federal Reserve will cut rates to stimulate the economy during a downturn.
Typically, short-term rates are lower than long-term rates due to the liquidity premium on longer-term bonds. However, in an inversion, short-term rates are higher because the market expects future rate cuts, driving demand for long-term bonds, which lowers their yields.
Risk structure of interest rate
Bonds with the same term to maturity have different interest rates.
The relationship among these interest rates is called the risk structure of interest rates
- risk, liquidity and income tax rules all play a role in determining risk structure
Term structure of interest rates
Bonds with same risk structure have different interest rates
A bond’s term to maturity also affects interest rate
Relationship among interest rates on bonds with different terms to maturity is called term structure of interest rates
