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SPREAD MEASURES
Participants in the ¬‚oater market commonly refer to various “spread”
measures that an issue is trading over its reference rate. These measures
include spread for life, adjusted simple margin, adjusted total margin,
discount margin, and option-adjusted spread. We conclude this chapter
with an explanation of these measures along with their limitations. All
of these spread measures are available on Bloomberg™s Yield Analysis
(YA) screen. We begin with a discussion of the concept of current yield
and how to compare ¬‚oaters with different reset dates.

Current Yield
The current yield of a ¬‚oater is calculated by dividing the security™s
annual dollar cash ¬‚ow (assuming that the reference rate does not
109
Floating-Rate Securities



change over the security™s life) by the market price. The formula for the
current yield is

Annual dollar cash flow
Current yield = -------------------------------------------------------------
- (1)
Price

To illustrate the calculation, suppose that the coupon formula for a
6-year ¬‚oater selling for $99.3098 is 6-month LIBOR plus 80 basis
points (i.e., the quoted margin). The coupon rate is reset every six
months. Assume the current value for the reference rate is 10%. The
calculation is shown below:

Annual dollar cash ¬‚ow = $100 — 0.1080 = $10.80

$10.80
Current yield = ------------------------ = 0.10875 = 10.875%
-
$99.3098

Current yield possesses a number of drawbacks as a potential return
measure. First, the measure assumes that the reference rate will not
change over the security™s life. Second, current yield considers only cou-
pon interest and no other source of return that will affect an investor™s
yield. Simply put, the current yield assumes that the ¬‚oater delivers a
perpetual annuity. Third, current yield ignores the potential impact of
any embedded options.

Comparing Floaters with Different Reset Dates
To compare the current yields of two ¬‚oaters with different coupon
reset dates, an adjustment known as the weighted average rate is uti-
lized. The comparison requires two assumptions: (1) the coupon pay-
ments of the two ¬‚oaters are determined using the same reference rate
and (2) the frequency with which the coupon payments are reset is the
same (e.g., semiannually, monthly, etc.). It is presumed that two ¬‚oaters
that share these attributes will produce the same current yield regardless
of their respective terms to maturity.
The weighted average rate is simply the weighted average coupon
rate over some anticipated holding period where the weights are the
fraction of the holding period prior to the coupon reset date and the
fraction of the holding period subsequent to the coupon reset date. (The
holding period is assumed to contain only one coupon reset date.
Accordingly, it is presumed an investor is considering the purchase of a
¬‚oater as an alternative to a money market instrument.) On the reset
110 THE GLOBAL MONEY MARKETS



date, it is assumed the new coupon rate is the current value of the refer-
ence rate adjusted for a spread. The formula for the weighted average
rate is given by:

Weighted average rate
( Current coupon — w ) + [ Assumed new coupon — ( 1 “ w ) ] (2)
= -----------------------------------------------------------------------------------------------------------------------------------------------------
-
Number of days in the holding period

where w is the number of days to the coupon reset date divided by the
number of days in the anticipated holding period. The ¬‚oater™s current
yield is then determined by dividing the weighted average rate by the
market price.
To illustrate the calculation, suppose an investor is considering the
purchase of one of two ¬‚oaters for an anticipated holding period of 180
days. The purchase candidates are two issues with identical coupon for-
mulas of 6-month LIBOR plus 90 basis points. Security A has a current
coupon of 6.80%, matures in three years, and is trading at 99.50. Secu-
rity B has a current coupon of 7%, matures in ¬ve years, and is trading
at 99.125. These two securities also differ in coupon reset dates: Secu-
rity A resets in 30 days while Security B resets in 90 days. Suppose the
current value of the reference rate (6-month LIBOR) is 6.20%. Accord-
ingly, the assumed new coupon rate for both Securities A and B is
7.10% since they share the same quoted margin.
The weighted average rate for Security A and the accompanying
current yield using the weighted average rate is computed below:

( 6.80% — 30 ) + ( 7.10% — 150 )
Weighted average rate = ------------------------------------------------------------------------- = 7.05%
-
180

Annual dollar cash ¬‚ow = $100 — 0.0705 = $7.05

$7.05
Current yield using weighted average rate = ----------------- = 0.07085 = 7.085%
-
$99.50

The weighted average rate for Security B and the accompanying cur-
rent yield using the weighted average rate is computed below:

( 7% — 90 ) + ( 7.10% — 90 )
Weighted average rate = -------------------------------------------------------------------- = 7.05%
-
180
111
Floating-Rate Securities



Annual dollar cash ¬‚ow = $100 — 0.0705 = $7.05

$7.05
Current yield using weighted average rate = -------------------- = 7.11%
-
$99.125

Although Security A carries a lower coupon rate, it resets sooner to the
higher rate. As a result, the current yield of the two securities is closer
than one would expect.

Margin Measures
There are several yield spread measures or margins that are routinely
used to evaluate ¬‚oaters. The four margins commonly used are spread
for life, adjusted simple margin, adjusted total margin, and discount
margin. We will illustrate the calculations of these margins with a ¬‚oat-
ing-rate note issued by Enron Corp. (ticker symbol “ENE 03/00”) that
matured March 30, 2000. This issue contained no embedded options.
The ¬‚oater had a coupon formula equal to 3-month LIBOR plus 45
basis points and delivered cash ¬‚ows quarterly. The Yield Analysis
screen (YA) from Bloomberg is presented in Exhibit 7.1. We will illus-
trate the calculation of each of the four margin measures in turn.

EXHIBIT 7.1 Bloomberg™s Yield Analysis Screen for Enron Floater




Source: Bloomberg Financial Markets
112 THE GLOBAL MONEY MARKETS



Spread for Life
When a ¬‚oater is selling at a premium/discount to par, a potential buyer
of a ¬‚oater will consider the premium or discount as an additional
source of dollar return. Spread for life (also called simple margin) is a
measure of potential return that accounts for the accretion (amortiza-
tion) of the discount (premium) as well as the constant index spread
over the security™s remaining life. Spread for life is calculated using the
following formula:

100 ( 100 “ P )
Spread for life = ---------------------------------- + Quoted margin 100
---------
- (3)
Maturity P

where P is the market price (per $100 of par value) and Maturity is in
years using the appropriate day count convention. The quoted margin is
measured in basis points.
To illustrate this calculation, at the time of the analysis the Enron
¬‚oater had a current coupon of 5.45, matured in 345 days or 0.9583 of
a year using an ACT/360. Although there is no current market quote
available for this ¬‚oater as indicated by the words “NOT PRICED” at
the top center of the screen, we will use the Bloomberg default price of
99.99 for the current market price P. The simple margin is calculated as
follows

100 ( 100 “ 99.99 ) 100
Spread for life = --------------------------------------------- + 45 -------------- = 46.0481 basis points
-
-
99.99
0.9583

At the bottom of the YA screen in Exhibit 7.1 is a box labeled “MAR-
GINS.” The Enron ¬‚oater™s spread for life is 46.06. The slight difference
between our calculation and Bloomberg™s is likely due to rounding error.
Note also that spread for life considers only the accretion/amortization
of the discount/premium over the ¬‚oater™s remaining term to maturity
and considers neither the level of the coupon rate nor the time value of
money.

Adjusted Simple Margin
The adjusted simple margin (also called effective margin) is an adjust-
ment to spread for life. This adjustment accounts for a one-time cost of
carry effect when a ¬‚oater is purchased with borrowed funds. Suppose
an investor has purchased $10 million of a particular ¬‚oater. A lever-
aged investor has a number of alternative ways to ¬nance the position,
the most common being via a repurchase agreement. Regardless of the
113
Floating-Rate Securities



method selected, the investor must make a one-time adjustment to the
¬‚oater™s price to account for the cost of carry from the settlement date
to next coupon reset date. Given a particular ¬nancing rate, a carry-
adjusted forward price can be determined as of the next coupon reset
date. Once the carry-adjusted price is determined, the ¬‚oater™s adjusted
price is simply the carry-adjusted price discounted to the settlement date
by the reference rate. As before, the reference rate is assumed to remain
constant until maturity. Note the cost of carry adjustment is simply an
adjustment to the purchase price of the ¬‚oater. If the cost of carry is
positive (negative), the purchase price will be adjusted downward
(upward). A ¬‚oater™s adjusted price is calculated as below:

[ ( Coupon rate )100 “ ( P + AI )rf ]w
Adjusted price = P “ ------------------------------------------------------------------------------------------ (4)
[ 1 + ( w ) ( rr avg ) ]


where

Coupon rate = current coupon rate of the ¬‚oater (in decimal)
P = market price (per $100 of par value)
AI = accrued interest (per $100 of par value)
rf = ¬nancing rate (e.g., the repo rate) (in decimal)

Number of days between settlement and the next coupon payent
w = ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
-
Number of days in a year using the appropriate day-count


rravg = assumed (average) value for the reference rate until matu-
rity (in decimal)

To illustrate this calculation, we revisit the Enron ¬‚oater. The fol-
lowing information is taken from the YA screen in Exhibit 7.1. The
market price is 99.99 is taken from the “PRICES” box on the left-hand
side of the screen. For the coupon rate, we use 0.0545 (in decimal)
which is located under “FIX RATE.” The accrued interest is 0.3179 (per
$100 of par value). Under “INPUTS,” we ¬nd the repo rate (0.049755)
to the next coupon reset date. There are 71 days between the settlement
date (4/20/99) and the next coupon reset date (6/30/99) and the day
count is ACT/360. Given this information, w = 71/360 or 0.1972.
Lastly, the assumed value of the reference rate until maturity (rravg) is
simply the current value of the reference rate which is 0.05 (in decimal)
and is labeled “ASSUMED INDEX” under the “INPUTS” section.
114 THE GLOBAL MONEY MARKETS




Adjusted price
[ ( 0.0545 )100 “ ( 99.99 + 0.3179 )0.049755 ]0.1972
= 99.99 “ ------------------------------------------------------------------------------------------------------------------------------------
-
[ 1 + ( 0.1972 ) ( 0.05 ) ]
= 99.90033

The adjusted price as computed by Bloomberg is 99.90031 and is found
under “PRICES.”
Once the adjusted price is determined, the adjusted simple margin is
computed using the formula below.

100 ( 100 “ P A ) 100
Adjusted simple margin = ------------------------------------- + Quoted margin ---------
-
- (5)
PA
Maturity


where PA is the adjusted price, Maturity is measured in years using the
appropriate day count convention, and Quoted margin is measured in
basis points.
To compute the adjusted simple margin for the Enron ¬‚oater, we
gather the following information from Exhibit 7.1. We use the adjusted
price of 99.90031 for PA. There are 345 days between the settlement date
(4/20/99) and the maturity date (3/30/00). Since the day count conven-
tion is ACT/360, the maturity is 345/360 or 0.9583. The quoted margin
of 45 basis points is obtained from the “INPUTS” box. Plugging this
information into equation (5), we obtain the adjusted simple margin.

100 ( 100 “ 99.90031 ) 100
Adjusted simple margin = ------------------------------------------------------- + 45 ------------------------
-
-
99.90031
0.9583 (6)
= 55.458 basis points

The adjusted simple margin from Bloomberg is 55.458 which is also
located in the “MARGINS” box at the bottom of Exhibit 7.1.

Adjusted Total Margin
The adjusted total margin (also called total adjusted margin) adds one
additional re¬nement to the adjusted simple margin. Speci¬cally, the
adjusted total margin is the adjusted simple margin plus the interest
earned by investing the difference between the ¬‚oater™s par value and
the adjusted price. The current value of the reference rate (i.e., the
assumed index) is assumed to be the investment rate. The adjusted total
margin is calculated using the following expression:
115
Floating-Rate Securities




Adjusted total margin
100 ( 100 “ P A ) 100 (7)
= ------------------------------------- + Quoted margin + 100 ( 100 “ P A )rr avg ---------
-
-
PA
Maturity

The notation used is the same as given above.
For the Enron ¬‚oater we used in previous illustrations, the adjusted
total margin is:

Adjusted total margin
100 ( 100 “ 99.90031 ) 100
= ------------------------------------------------------- + 45 + 100 ( 100 “ 99.90031 )0.05 ------------------------
-
-
99.90031
0.9583
= 55.957 basis points

In Exhibit 7.1, Bloomberg™s adjusted total margin is 55.957 which is
obtained from the “MARGINS” box.

Discount Margin
One common method of measuring potential return that employs dis-
counted cash ¬‚ows is discount margin. This measure indicates the aver-
age spread or margin over the reference rate the investor can expect to
earn over the security™s life given a particular assumption of the path the
reference rate will take to maturity. The assumption that the future lev-
els of the reference rate are equal to today™s level is the usual assump-
tion. The procedure for calculating the discount margin is as follows:

Step 1. Determine the cash flows assuming that the reference rate does
not change over the security™s life.
Step 2. Select a margin.
Step 3. Discount the cash flows found in Step 1 by the current value of
the reference rate plus the margin selected in Step 2.
Step 4. Compare the present value of the cash flows as calculated in
Step 3 to the price. If the present value is equal to the security™s price,
the discount margin is the margin assumed in Step 2. If the present
value is not equal to the security™s price, go back to Step 2 and select a
different margin.

For a security selling at par, the discount margin is simply the quoted
margin.
For example, suppose that a 6-year ¬‚oater selling for $99.3098 pays
the reference rate plus a quoted margin of 80 basis points. The coupon
resets every six months. Assume that the current value of the reference rate
is 10%.
Exhibit 7.2 presents the calculation of the discount margin for this secu-
rity. Each period in the security™s life is enumerated in Column (1), while Col-
umn (2) shows the current value of the reference rate. Column (3) sets forth
the security™s cash ¬‚ows. For the ¬rst 11 periods, the cash ¬‚ow is equal to the
reference rate (10%) plus the quoted margin of 80 basis points multiplied by
100 and then divided by 2. In last 6-month period, the cash ¬‚ow is $105.40”
the ¬nal coupon payment of $5.40 plus the maturity value of $100. Different
assumed margins appear at the top of the last ¬ve columns. The rows below
the assumed margin indicate the present value of each period™s cash ¬‚ow for
that particular value of assumed margin. Finally, the last row gives the total
present value of the cash ¬‚ows for each assumed margin.

EXHIBIT 7.2 Calculation of the Discount Margin for a Floater
Floater: Maturity = 6 years
Coupon rate = Reference rate + 80 basis points
Resets every 6 months
Maturity value = $100


(1) (2) (3) (4) (5) (6) (7) (8)
Rate Flow Assumed Margin
Period (%) ($)* 80 84 88 96 100

1 10 5.40 $5.1233 $5.1224 $5.1214 $5.1195 $5.1185
2 10 5.40 4.8609 4.8590 4.8572 4.8535 4.8516
3 10 5.40 4.6118 4.6092 4.6066 4.6013 4.5987
4 10 5.40 4.3755 4.3722 4.3689 4.3623 4.3590
5 10 5.40 4.1514 4.1474 4.1435 4.1356 4.1317
6 10 5.40 3.9387 3.9342 3.9297 3.9208 3.9163
7 10 5.40 3.7369 3.7319 3.7270 3.7171 3.7122
8 10 5.40 3.5454 3.5401 3.5347 3.5240 3.5186
9 10 5.40 3.3638 3.3580 3.3523 3.3409 3.3352
10 10 5.40 3.1914 3.1854 3.1794 3.1673 3.1613
11 10 5.40 3.0279 3.0216 3.0153 3.0028 2.9965
12 10 105.40 56.0729 55.9454 55.8182 55.5647 55.4385
Present value = $100.00 $99.8269 $99.6541 $99.3098 $99.1381


* For periods 1-11: Cash flow = 100(Reference rate + 80 basis points) (0.5)
For period 12: Cash flow = 100(Reference rate + 80 basis points) (0.5) + 100
117
Floating-Rate Securities



For the ¬ve assumed margins, the present value of the cash ¬‚ows is
equal to the ¬‚oater™s price ($99.3098) when the assumed margin is 96
basis points. Accordingly, the discount margin on a semiannual basis is
48 basis points and correspondingly 96 basis points on an annual basis.
(Notice that the discount margin is 80 basis points (i.e., the quoted mar-
gin) when the ¬‚oater is selling at par.)
There are several drawbacks of the discount margin as a measure of
potential return from holding a ¬‚oater. First and most obvious, the mea-
sure assumes the reference rate will not change over the security™s life.
Second, the price of a ¬‚oater for a given discount margin is sensitive to
the path that the reference rate takes in the future except in the special
case when the discount margin equals the quoted margin.

Option-Adjusted Spread
The spread measures discussed thus far fail to recognize any embedded
options that may be present in a ¬‚oater. A spread measure that takes
into account embedded options is the option-adjusted spread. A discus-
sion of how this spread measure is computed is beyond the scope of this
chapter.4 Basically, it is a byproduct of a model that is used for valuing a
security with an embedded option. The spread is referred to as “option
adjusted” because the valuation model adjusts the cash ¬‚ows based on
how changes in the reference rates might be expected to change the cash
¬‚ows of the security, taking into account any embedded options.
Despite its widespread use, the OAS has a number of limitations.
Speci¬cally, the OAS is model-dependent. Changing the assumptions of
the valuation model may produce substantial differences in the com-
puted OAS.




4
See Chapter 4 in Frank J. Fabozzi and Steven V. Mann, Floating-Rate Securities
(New Hope, PA: Frank J. Fabozzi Associates, 2000).
8
CHAPTER

Repurchase and Reverse
Repurchase Agreements



ne of the largest segments of the money markets worldwide is the market
O in repurchase agreements or repos. A most ef¬cient mechanism by which
to ¬nance bond positions, repo transactions enable market makers to take
long and short positions in a ¬‚exible manner, buying and selling according
to customer demand on a relatively small capital base. Repo is also a ¬‚exible
and relatively safe investment opportunity for short-term investors. The
ability to execute repo is particularly important to ¬rms in less-developed
countries who might not have access to a deposit base. Moreover, in coun-
tries where no repo market exists, funding is in the form of unsecured lines
of credit from the banking system which is restrictive for some market par-
ticipants. A liquid repo market is often cited as a key ingredient of a liquid
bond market. In the United States, repo is a well-established money market
instrument and is developing in a similar way in Europe and Asia.
A repurchase agreement or “repo” is the sale of a security with a com-
mitment by the seller to buy the same security back from the purchaser at a
speci¬ed price at a designated future date. For example, a dealer who owns
a 10-year U.S. Treasury note might agree to sell this security (the “seller”)
to a mutual fund (the “buyer”) for cash today while simultaneously agree-
ing to buy the same 10-year note back at a certain date in the future (or in
some cases on demand) for a predetermined price. The price at which the
seller must subsequently repurchase the security is called the repurchase
price and the date that the security must be repurchased is called the repur-
chase date.1 Simply put, a repurchase agreement is a collateralized loan
where the collateral is the security that is sold and subsequently repur-

1 Asnoted, repurchase agreements can be structured such that the transaction is ter-
minable on demand.

119
120 THE GLOBAL MONEY MARKETS



chased. One party (the “seller”) is borrowing money and providing collat-
eral for the loan; the other party (the “buyer”) is lending money and
accepting a security as collateral for the loan. To the borrower, the advan-
tage of a repurchase agreement is that the short-term borrowing rate is
lower than the cost of bank ¬nancing, as we will see shortly. To the lender,
the repo market offers an attractive yield on a short-term secured transac-
tion that is highly liquid. This latter aspect is the focus of this chapter.


THE BASICS
Suppose a government securities dealer purchases a 5% coupon Treasury
note that matures on August 15, 2011 with a settlement date of Thurs-
day, November 15, 2001. The face amount of the position is $1 million
and the note™s full price (i.e., ¬‚at price plus accrued interest) is
$1,044,843.75. Further, suppose the dealer wants to hold the position
until the end of the next business day which is Friday, November 16,
2001. Where does the dealer obtain the funds to ¬nance this position?
Of course, the dealer can ¬nance the position with its own funds or by
borrowing from a bank. Typically, though, the dealer uses a repurchase agree-
ment or “repo” market to obtain ¬nancing. In the repo market, the dealer
can use the purchased Treasury note as collateral for a loan. The term of the
loan and the interest rate a dealer agrees to pay are speci¬ed. The interest rate
is called the repo rate. When the term of a repo is one day, it is called an over-
night repo. Conversely, 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 security™s sale and its repurchase at a future date. Both the sale price and
the purchase price are speci¬ed in the agreement. The difference between the
purchase (repurchase) price and the sale price is the loan™s dollar interest cost.
Let us return now to the dealer who needs to ¬nance the Treasury note
that it purchased and plans to hold it overnight. We will illustrate this
transaction using Bloomberg™s Repo/Reverse Repo Analysis screen
(RRRA) that appears in Exhibit 8.1. The settlement date is the day that the
collateral must be delivered and the money lent to initiate the transaction.
Likewise, the termination date of the repo agreement is November 16,
2001 and appears in the lower left-hand corner. At this point we need to
ask, who is the dealer™s counterparty (i.e., the lender of funds). Suppose
that one of the dealer™s customers has excess funds in the amount of
$1,044,843.75 labeled “SETTLEMENT MONEY” in Exhibit 8.1 and is
the amount of money loaned in the repo agreement.2 On November 15,

2 For example, the customer might be a municipality with tax receipts that it has just
collected and no immediate need to disburse the funds.
121
Repurchase and Reverse Repurchase Agreements



2001, the dealer would agree to deliver (“sell”) $1,044,843.75 worth of
Treasury notes to the customer and buy the same Treasury security for an
amount determined by the repo rate the next day on November 16, 2001.3
Suppose the repo rate in this transaction is 1.83% which is shown in
the upper right-hand corner of the screen. Then, as will be explained below,
the dealer would agree to deliver the Treasury note for $1,044,843.75 and
repurchase the same security for $1,044,896.86 the next day. The $53.11
difference between the “sale” price of $1,044,843.75 and the repurchase
price of $1,044,896.86 is the dollar interest on the ¬nancing.

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

dollar interest = (dollar principal) — (repo rate) — (repo term/360)

EXHIBIT 8.1 Bloomberg Repo/Reverse Repo Analysis Screen




Source: Bloomberg Financial Markets

3 We are assuming in this illustration that the borrower will provide collateral that
is equal in value to the money that is loaned. In practice, lenders require borrowers
to provide collateral in excess of the value of money that is loaned. We will illustrate
how this is accomplished shortly when we discuss repo margins.
122 THE GLOBAL MONEY MARKETS



Notice that the interest is computed using a day count convention of
Actual/360 like most money market instruments. In our illustration, using
a repo rate of 1.83% and a repo term of one day, the dollar interest is
$53.11 as shown below:

$1,044,843.75 — 0.0183 — (1/360) = $53.11

This calculation agrees with repo interest as calculated in the lower
right-hand corner of Exhibit 8.1.
The advantage to the dealer of using the repo market for borrowing
on a short-term basis is that the rate is lower than the cost of bank ¬nanc-
ing for reasons explained shortly. From the customer™s perspective (i.e.,
the lender), the repo market offers an attractive yield on a short-term
secured transaction that is highly liquid.

Reverse Repo and Market Jargon
In the illustration presented above, the dealer is using the repo market
to obtain ¬nancing for a long position. Dealers can also use the repo
market to cover a short position. For example, suppose a government
dealer established a short position in the 30-year Treasury bond one
week ago and must now cover the position”namely, deliver the securi-
ties. The dealer accomplishes this task by engaging in a reverse repo. In
a reverse repo, the dealer agrees to buy securities at a speci¬ed price
with a commitment to sell them back at a later date for another speci-
¬ed price.4 In this case, the dealer is making collateralized loan to its
customer. The customer is lending securities and borrowing funds
obtained from the collateralized loan to create leverage.
There is a great deal of Wall Street jargon surrounding repo transac-
tions. In order to decipher the terminology, remember that one party is
lending money and accepting a security as collateral for the loan; the
other party is borrowing money and providing collateral to borrow the
money. By convention, whether the transaction is called a repo or a
reverse repo is determined by viewing the transaction from the dealer™s
perspective. If the dealer is borrowing money from a customer and pro-
viding securities as collateral, the transaction is called a repo. If the dealer
is borrowing securities (which serve as collateral) and lends money to a
customer, the transaction is called a reverse repo.
When someone lends securities in order to receive cash (i.e., borrow
money), that party is said to be “reversing out” securities. Correspond-


4 Of course, the dealer eventually would have to buy the 30-year bonds in the market

in order to cover its short position.
123
Repurchase and Reverse Repurchase Agreements



ingly, a party that lends money with the security as collateral for the loan
is said to be “reversing in” securities.
The expressions “to repo securities” and “to do repo” are also com-
monly used. The former means that someone is going to ¬nance securities
using the securities as collateral; the latter means that the party is going to
invest in a repo as a money market instrument.
Lastly, the expressions “selling collateral” and “buying collateral”
are used to describe a party ¬nancing a security with a repo on the one
hand, and lending on the basis of collateral on the other.
Rather than relying on industry jargon, investment guidelines should
clearly state what a portfolio manager is permitted to do. For example, a
client may have no objections to its portfolio manager using a repo to
invest funds short-term (i.e., lend at the repo rate). The investment guide-
lines should set forth how the loan arrangement should be structured to
protect against credit risk. We will discuss these procedures in the next
section. Conversely, if a client does not want a portfolio manager to use a
repurchase agreement as a vehicle for borrowing funds (thereby, creating
leverage), it should state so clearly.

Types of Collateral
While in our illustration, we use a Treasury security as collateral, the collat-
eral in a repo is not limited to government securities. Money market instru-
ments, federal agency securities, and mortgage-backed securities are also
used. In some specialized markets, even whole loans are used as collateral.

Documentation
Most repo market participants in the United States use the Master
Repurchase Agreement published by Bond Market Association. Para-
graphs 1 (“Applicability”), 2 (“De¬nitions”), 4 (“Margin Mainte-
nance”), 8 (“Segregation of Purchased Securities”), 11 (“Events of
Default”), and 19 (“Intent”) of this agreement are reproduced in the
appendix to this chapter. In Europe, the Global Master Repurchase
Agreement published by the Bond Market Association (formerly, the
Public Securities Association) and the International Securities Market
Association has become widely accepted. The full agreement may be
downloaded from www.isma.org.



CREDIT RISKS
Just as in any borrowing/lending agreement, both parties in a repo trans-
action are exposed to credit risk. This is true even though there may be
124 THE GLOBAL MONEY MARKETS



high-quality collateral underlying the repo transaction. Consider our ini-
tial example in Exhibit 8.1 where the dealer uses U.S. Treasuries as col-
lateral to borrow funds. Let us examine under which circumstances each
counterparty is exposed to credit risk.
Suppose the dealer (i.e., the borrower) defaults such that the Treasur-
ies are not repurchased on the repurchase date. The investor gains control
over the collateral and retains any income owed to the borrower. The risk
is that Treasury yields have risen subsequent to the repo transaction such
that the market value of collateral is worth less than the unpaid repurchase
price. Conversely, suppose the investor (i.e., the lender) defaults such that
the investor fails to deliver the Treasuries on the repurchase date. The risk
is that Treasury yields have fallen over the agreement™s life such that the
dealer now holds an amount of dollars worth less then the market value of
collateral. In this instance, the investor is liable for any excess of the price
paid by the dealer for replacement securities over the repurchase price.5

Repo Margin
While both parties are exposed to credit risk in a repo transaction, the
lender of funds is usually in the more vulnerable position. Accordingly,
the repo is structured to reduce the lender™s credit risk. Speci¬cally, the
amount lent should be less than the market value of the security used as
collateral, thereby providing the lender some cushion should the collat-
eral™s market value decline. The amount by which the market value of
the security used as collateral exceeds the value of the loan is called repo
margin or “haircut.” Repo margins vary from transaction to transaction
and are negotiated between the counterparties based on factors such as
the following: term of the repo agreement, quality of the collateral, cred-
itworthiness of the counterparties, and the availability of the collateral.
Minimum repo margins are set differently across ¬rms and are based on
models and/or guidelines created by their credit departments. Repo mar-
gin is generally between 1% and 3%. For borrowers of lower credit wor-
thiness and/or when less liquid securities are used as collateral, the repo
margin can be 10% or more.
At the time of this writing, the Basel Committee on Banking Supervi-
sion is proposing standards for repo margins for capital-market driven
transactions (i.e., repo/reverse repos, securities borrowing/lending, deriv-
atives transactions, and margin lending).6 These standards would only
apply to banks.
5 See Section 11 “Events of Default” of the Master Repurchase Agreement repro-
duced in the appendix to this chapter.
6 The revised Basel Accord is in exposure draft form until May 31, 2001 and the final

document will be published before June 30, 2002.
125
Repurchase and Reverse Repurchase Agreements



EXHIBIT 8.2 Bloomberg Repo/Reverse Repo Analysis Screen




Source: Bloomberg Financial Markets

To illustrate the role of a haircut in a repurchase agreement, let us
once again return to the government securities dealer who purchases a
5% coupon, 10-year Treasury note and needs ¬nancing overnight.
Recall, the face amount of the position is $1 million and the note™s full
price (i.e., ¬‚at price plus accrued interest) is $1,044,843.75. As before,
we will use Bloomberg™s RRRA screen to illustrate the transaction in
Exhibit 8.2.
When a haircut is included, the amount the customer is willing to
lend is reduced by a given percentage of the security™s market value. In
this case, the collateral is 102% of the amount being lent. This percent-
age appears in the box labeled “COLLATERAL” in the upper right-
hand corner of the screen. Accordingly, to determine the amount being
lent, we divide the note™s full price of $1,044,843.75 by 1.02 to obtain
$1,024,356.62 which is labeled “SETTLEMENT MONEY” located on
the right-hand side of the screen. Suppose the repo rate in this transac-
tion is 1.83%. Then, the dealer would agree to deliver the Treasury
notes for $1,024,356.62 and repurchase the same securities for
$1,024,408.69 the next day. The $52.07 difference between the “sale”
price of $1,024,356.62 and the repurchase price of $1,024,408.69 is the
dollar interest on the ¬nancing. Using a repo rate of 1.83% and a repo
term of 1 day, the dollar interest is calculated as shown below:
126 THE GLOBAL MONEY MARKETS



$1,024,356.62 — 0.0183 — (1/360) = $52.07

This calculation agrees with repo interest as calculated in the lower
right-hand corner of Exhibit 8.2.

Marking the Collateral to Market
Another practice to limit credit risk is to mark the collateral to market on
a regular basis. Marking a position to market means simply recording the
position™s value at its market value. When the market value changes by a
certain percentage, the repo position is adjusted accordingly. The decline
in market value below a speci¬ed amount will result in a margin de¬cit.
[Paragraph 4(a) of the Master Repurchase Agreement (reproduced in the
appendix) gives the “Seller” (the dealer/borrower in our example) the
option to remedy the margin de¬cit by either providing additional cash
or by transferring “additional Securities reasonably acceptable to Buyer.”
The Buyer in our example is the investor/lender.] Conversely, suppose
instead that the market value rises above the amount required by margin.
This circumstance results in a margin excess. If this occurs, Paragraph
4(b) states the “Buyer” will remedy the excess by either transferring cash
equal to the amount of the excess or returning a portion of the collateral
(“purchased securities”) to the “Seller.”
Since the Master Repurchase Agreement covers all transactions where
a party is on one side of the transaction, the discussion of margin mainte-
nance in Paragraph 4 is couched in terms of “the aggregate Market Value
of all Purchased Securities in which a particular party hereto is acting as
Buyer” and “the aggregate Buyer™s Margin Account for all such Transac-
tions.” Thus, maintenance margin is not viewed from an individual trans-
action or security perspective. However, Paragraph 4(f) permits the
“Buyer” and “Seller” to agree to override this provision so as to apply the
margin maintenance requirement to a single transaction.
The price used to mark positions to market is de¬ned in Paragraph
2(j)”the de¬nition of “Market Value.” The price is one “obtained from a
generally recognized source agreed to by the parties or the most recent
closing bid quotation from such a source.” For complex securities that do
not trade frequently, there is considerable dif¬culty in obtaining a price at
which to mark a position to market.

Delivery of the Collateral
One concern in structuring a repurchase agreement is delivery of the col-
lateral to the lender. The most obvious procedure is for the borrower to
actually deliver the collateral to the lender or to the cash lender™s clearing
agent. If this procedure is followed, the collateral is said to be “delivered
127
Repurchase and Reverse Repurchase Agreements



out.” At the end of the repo term, the lender returns collateral to the bor-
rower in exchange for the repurchase price (i.e., the amount borrowed
plus interest).
The drawback of this procedure is that it may be too expensive, par-
ticularly for short-term repos (e.g., overnight) owing to the costs associ-
ated with delivering the collateral. Indeed, the cost of delivery is factored
into the repo rate of the transaction in that if delivery is required this
translates into a lower repo rate paid by the borrower. If delivery of col-
lateral is not required, an otherwise higher repo rate is paid. The risk to
the lender of not taking actual possession of the collateral is that the bor-
rower may sell the security or use the same security as collateral for a
repo with another counterparty.
As an alternative to delivering out the collateral, the lender may agree
to allow the borrower to hold the security in a segregated customer
account. The lender still must bear the risk that the borrower may use the
collateral fraudulently by offering it as collateral for another repo trans-
action. If the borrower of the cash does not deliver out the collateral, but
instead holds it, then the transaction is called a hold-in-custody repo
(HIC repo). Despite the credit risk associated with a HIC repo, it is used
in some transactions when the collateral is dif¬cult to deliver (e.g., whole
loans) or the transaction amount is relatively small and the lender of
funds is comfortable with the borrower™s reputation.
Investors participating in a HIC repo must ensure: (1) they transact
only with dealers of good credit quality since an HIC repo may be per-
ceived as an unsecured transaction and (2) the investor (i.e., the lender of
cash) receives a higher rate in order to compensate them for the higher
credit risk involved. In the U.S. market, there have been cases where
dealer ¬rms that went into bankruptcy and defaulted on loans were found
to have pledged the same collateral for multiple HIC transactions.
Another method for handling the collateral is for the borrower to
deliver the collateral to the lender™s custodial account at the borrower™s
clearing bank. The custodian then has possession of the collateral that it
holds on the lender™s behalf. This method reduces the cost of delivery
because it is merely a transfer within the borrower™s clearing bank. If, for
example, a dealer enters into an overnight repo with Customer A, the
next day the collateral is transferred back to the dealer. The dealer can
then enter into a repo with Customer B for, say, ¬ve days without having
to redeliver the collateral. The clearing bank simply establishes a custo-
dian account for Customer B and holds the collateral in that account. In
this type of repo transaction, the clearing bank is an agent to both parties.
This specialized type of repo arrangement is called a tri-party repo. For
some regulated ¬nancial institutions (e.g., federally chartered credit
unions), this is the only type of repo arrangement permitted.
128 THE GLOBAL MONEY MARKETS



Paragraph 8 (“Segregation of Purchased Securities”) of the Master
Repurchase Agreement contains the language pertaining to the possession
of collateral. This paragraph also contains special disclosure provisions
when the “Seller” retains custody of the collateral.
Paragraph 11 (“Events of Default”) details the events that will trig-
ger a default of one of the counterparties and the options available to
the non-defaulting party. If the borrower ¬les for bankruptcy, the U.S.
bankruptcy code affords the lender of funds in a quali¬ed repo transac-
tion a special status. It does so by exempting certain types of repos from
the stay provisions of the bankruptcy law. This means that the lender of
funds can immediately liquidate the collateral to obtain cash. Paragraph
19 (“Intent”) of the Master Repurchase Agreement is included for this
purpose.



DETERMINANTS OF THE REPO RATE
Just as there is no single interest rate, there is not one repo rate. The repo
rate varies from transaction to transaction depending on a number of
factors: quality of the collateral, term of the repo, delivery requirement,
availability of the collateral, and the prevailing federal funds rate. Panel
A of Exhibit 8.3 presents a Bloomberg screen (MMR) that contains repo
and reverse repo rates for maturities of 1 day, 1 week, 2 weeks, 3 weeks,
1 month, 2 months, and 3 months using U.S. Treasuries as collateral on
November 15, 2001. Panel B presents repo and reverse repo rates with
agency securities as collateral. Note how the rates differ by maturity and
type of collateral. For example, the repo rates are higher when agency
securities are used as collateral versus governments. Moreover, the rates
generally decrease with maturity that mirrors the inverted Treasury yield
curve on that date.
Another pattern evident in these data is that repo rates are lower than
the reverse repo rates when matched by collateral type and maturity.
These repo (reverse repo) rates can viewed as the rates the dealer will bor-
row (lend) funds. Alternatively, repo (reverse repo) rates are prices at
which dealers are willing to buy (sell) collateral. While a dealer ¬rm pri-
marily uses the repo market as a vehicle for ¬nancing its inventory and
covering short positions, it will also use the repo market to run a
“matched book.” A dealer runs a matched book by simultaneously enter-
ing into a repo and a reverse repo for the same collateral with the same
maturity. The dealer does so to capture the spread at which it enters into
a repurchase agreement (i.e., an agreement to borrow funds) and a
reverse repurchase agreement (i.e., an agreement to lend funds).
129
Repurchase and Reverse Repurchase Agreements



EXHIBIT 8.3 Bloomberg Screens Presenting Repo and
Reverse Repo rates for Various Maturities and Collateral
Panel A: U.S. Treasuries




Panel B: Agency Securities




Source: Bloomberg Financial Markets
130 THE GLOBAL MONEY MARKETS



For example, suppose that a dealer enters into a term repo for one
month with a money market mutual fund and a reverse repo with a cor-
porate credit union for one month for which the collateral is identical. In
this arrangement, the dealer is borrowing funds from the money market
mutual fund and lending funds to the corporate credit union. From Panel
A in Exhibit 8.3, we ¬nd that the repo rate for a one-month repurchase
agreement is 1.90% and repo rate for a one-month reverse repurchase
agreement is 1.97%. If these two positions are established simultaneously,
then the dealer is borrowing at 1.90% and lending at 1.97% thereby
locking in a spread of 7 basis points.
However, in practice, traders deliberately mismatch their books to take
advantage of their expectations about the shape and level of the short-dated
yield curve. The term matched book is therefore something of a misnomer in
that most matched books are deliberately mismatched for this reason. Trad-
ers engage in positions to take advantage of (1) short-term interest rate
movements and (2) anticipated demand and supply in the underlying bond.
The delivery requirement for collateral also affects the level of the repo
rate. If delivery of the collateral to the lender is required, the repo rate will
be lower. Conversely, if the collateral can be deposited with the bank of the
borrower, a higher repo rate will be paid. For example, on November 15,
2001, Bloomberg reports that the general collateral rate (repos backed by
non-speci¬c collateral) is 2.10% if delivery of the collateral is required. For
a triparty repo discussed earlier, the general collateral rate is 2.13%.
The more dif¬cult it is to obtain the collateral, the lower the repo
rate. To understand why this is so, remember that the borrower (or equiv-
alently the seller of the collateral) has a security that lenders of cash want
for whatever reason.7 Such collateral is said to “on special.” Collateral
that does not share this characteristic is referred to as “general collat-
eral.” The party that needs collateral that is “on special” will be willing
to lend funds at a lower repo rate in order to obtain the collateral. For
example, on November 14, 2001, Bloomberg reports the on-the-run 5-
year Treasury note (3.5% coupon maturing November 15, 2006) was “on
special” such that the overnight repo rate was 0.65%. At the time, the
general collateral rate was 2.13%.
There are several factors contributing to the demand for special col-
lateral. They include:

– government bond auctions”the bond to be issued is shorted by dealers
in anticipation of new supply and due to client demand;
– outright short selling whether a deliberate position taken based on a
trader™s expectations or dealers shorting bonds to satisfy client demand;

7 Perhaps the issue is in great demand to satisfy borrowing needs.
131
Repurchase and Reverse Repurchase Agreements



– hedging including corporate bonds underwriters who short the relevant
maturity benchmark government bond that the corporate bond is
priced against;
– derivative trading such as basis trading creating a demand for a speci¬c
bond;
– buy-back or cancellation of debt at short notice.

Financial crises will also impact a particular security™s “specialness.”
Specialness is de¬ned the spread between the general collateral rate and
the repo rate of a particular security. Michael Fleming found that the on-
the-run 2-year note, 5-year note, and 30-year bond traded at an increased
rate of specialness during the Asian ¬nancial crisis of 1998. In other
words, the spread between the general collateral rate and the repo rates
on these securities increased. Moreover, these spreads returned to more
normal levels after the crisis ended.8
While these factors determine the repo rate on a particular transac-
tion, the federal funds rate (discussed in Chapter 6) determines the gen-
eral level of repo rates. The repo rate generally will trade lower than the
federal funds rate, because a repo involves collateralized borrowing
while a federal funds transaction is unsecured borrowing. Exhibit 8.4
presents a time series plot of the federal funds rate and the overnight
repo rate each day from October 2, 2000 to April 6, 2001 (129 observa-
tions). The overnight repo rate is on average 8.17 basis points below the
federal funds rate.9



SPECIAL COLLATERAL AND ARBITRAGE
As noted earlier in the chapter, there are a number of investment strate-
gies in which an investor borrows funds to purchase securities. The
investor™s expectation is that the return earned by investing in the securi-
ties purchased with the borrowed funds will exceed the borrowing cost.
The use of borrowed funds to obtain greater exposure to an asset than is
possible by using only cash is called leveraging. In certain circumstances,
a borrower of funds via a repo transaction can generate an arbitrage
opportunity. This occurs when it is possible to borrow funds at a lower
rate than the rate that can be earned by reinvesting those funds.


8 Michael J. Fleming, “The Benchmark U.S. Treasury Market: Recent Performance
and Possible Alternatives,” FRBNY Economic Policy Review (April 2000), pp. 129“
145.
9 Source: Bloomberg.
132 THE GLOBAL MONEY MARKETS



EXHIBIT 8.4 Time Series Plot of the Federal Funds Rate and Overnight Repo Rate




Source: Bloomberg Financial Markets

Such opportunities present themselves when a portfolio includes
securities that are “on special” and the manager can reinvest at a rate
higher than the repo rate. For example, suppose that a manager has
securities that are “on special” in the portfolio, Bond X, that lenders of
funds are willing to take as collateral for two weeks charging a repo rate
of say 3%. Suppose further that the manager can invest the funds in a 2-
week Treasury bill (the maturity date being the same as the term of the
repo) and earn 4%. Assuming that the repo is properly structured so
that there is no credit risk, then the manager has locked in a spread of
100 basis points for two weeks. This is a pure arbitrage and the man-
ager faces no risk. Of course, the manager is exposed to the risk that
Bond X may decline in value but this the manager is exposed to this risk
anyway as long as the manager intends to hold the security.
The Bank of England has conducted a study examining the relation-
ship between cash prices and repo rates for bonds that have traded spe-
cial.10 The results of the study suggest a positive correlation between
changes in a bond trading expensive to the yield curve and changes in the
degree to which it trades special. This result is not surprising. Traders
maintain short positions in bonds which have associated funding costs
only if the anticipated fall in the bond™s is large enough to engender a
pro¬t. The causality could run in either direction. For example, suppose a
10 Seethe markets section of the Bank of England™s Quarterly Bulletin in the Febru-
ary 1997 and August 1997 issues.
133
Repurchase and Reverse Repurchase Agreements



bond is perceived as being expensive relative to the yield curve. This cir-
cumstance creates a greater demand for short positions and hence a
greater demand for the bonds in the repo market to cover the short posi-
tions. Alternatively, suppose a bond goes on special in the repo market for
whatever reason. The bond would appreciate in price in the cash market
as traders close out their short positions which are now too expensive to
maintain. Moreover, traders and investors would try to buy the bond out-
right since it now would be relatively cheap to ¬nance in the repo market.



PARTICIPANTS IN THE MARKET
The repo market has evolved into one of the largest sectors of the money
market because it is used continuously by dealer ¬rms (investment banks
and money center banks acting as dealers) to ¬nance positions and cover
short positions. Exhibit 8.5 presents the average daily amount outstanding
(in billions of dollars) for reverse repurchase/repurchase agreements by U.S.
government securities dealers for the period 1981-2000.11 Financial and
non¬nancial ¬rms participate actively in the market as both sellers and
buyers of collateral depending on their circumstances. Depository institu-
tions are usually net sellers of collateral (i.e., net borrowers of funds);
money market mutual funds, bank trust departments, municipalities, and
corporations are usually net buyers of collateral (i.e., net lenders of funds).
Another repo market participant is the repo broker. To understand the
repo broker™s role, suppose that a dealer has shorted $50 million of the cur-
rent 10-year Treasury note. It will then query its regular customers to deter-
mine if it can borrow, via a reverse repo, the 10-year Treasury note it
shorted. Suppose that it cannot ¬nd a customer willing to do a repo transac-
tion (repo from the customer™s perspective, reverse repo from the dealer™s
perspective). At that point, the dealer will utilize the services of a repo bro-
ker who will ¬nd the desired collateral and arrange the transaction for a fee.



REPO MARKET STRUCTURES
Structured repo instruments have developed in recent years mainly in the
U.S. market where repo is widely accepted as a money market instru-
ment. Following the introduction of new repo types it is also possible
now to transact them in other liquid markets.

11 The collateral underlying these agreements is either U.S. Treasuries, agency deben-

tures, or agency MBS securities.
134 THE GLOBAL MONEY MARKETS



EXHIBIT 8.5 Average Daily Amount Outstanding (in billions of dollars) for
Reverse Repurchase/Repurchase Agreements

Year Reverse Repurchase Repurchase Total

1981 46.7 65.4 112.1
1982 75.1 95.2 170.3
1983 81.7 102.4 184.1
1984 112.4 132.6 245.0
1985 147.9 172.9 320.8
1986 207.7 244.5 452.2
1987 275.0 292.0 567.0
1988 313.6 309.7 623.3
1989 383.2 398.2 781.4
1990 377.1 413.5 790.5
1991 417.0 496.6 913.6
1992 511.1 628.2 1139.3
1993 594.1 765.6 1359.7
1994 651.2 825.9 1477.1
1995 618.8 821.5 1440.3
1996 718.1 973.7 1691.8
1997 883.0 1159.0 2042.0
1998 1111.4 1414.0 2525.5
1999 1070.1 1361.0 2431.1
2000 1093.3 1439.6 2532.9

Source: Federal Reserve Bank of New York

Cross-Currency Repo
A cross-currency repo is an agreement in which the cash lent and securi-
ties used as collateral are denominated in different currencies say, bor-
row U.S. dollars with UK gilts used as collateral. Of course, ¬‚uctuating
foreign exchange rates mean that it is likely that the transaction will
need to be marked-to-market frequently in order to ensure that cash or
securities remain fully collateralized.

Callable Repo
In a callable repo arrangement, the lender of cash in a term ¬xed-rate
repo has the option to terminate the repo early. In other words, the repo
transaction has an embedded interest rate option which bene¬ts the
lender of cash if rates rise during the repo™s term. If rates rise, the lender
135
Repurchase and Reverse Repurchase Agreements



may exercise the option to call back the cash and reinvest at a higher
rate. For this reason, a callable repo will trade at a lower repo rate than
an otherwise similar conventional repo.

Whole Loan Repo
A whole loan repo structure developed in the U.S. market as a response
to investor demand for higher yields in a falling interest rate environ-
ment. Whole loan repo trades at a higher rate than conventional repo
because a lower quality collateral is used in the transaction. There are
generally two types: mortgage whole loans and consumer whole loans.
Both are unsecuritized loans or interest receivables. The loans can also
be credit card payments and other types of consumer loans. Lenders in a
whole loan repo are not only exposed to credit risk but prepayment risk
as well. This is the risk that the loan package is paid off prior to the
maturity date which is often the case with consumer loans. For these
reasons, the yield on a whole loan repo is higher than conventional repo
collateralized by say U.S. Treasuries, trading at around 20-30 basis
points over LIBOR.

Total Return Swap
A total return swap structure, also known as a “total rate of return
swap,” is economically identical to a repo. Swaps are discussed in Chap-
ter 12. The main difference between a total return swap and a repo is
that the former is governed by the International Swap Dealers Associa-
tion (ISDA) agreement as opposed to a repo agreement. This difference
is largely due to the way the transaction is re¬‚ected on the balance sheet
in that a total return swap is recorded as an off-balance sheet transac-
tion. This is one of the main motivations for entering into this type of
contract. The transaction works as follows:

1. the institution sells the security at the market price
2. the institution executes a swap transaction for a ¬xed term, exchanging
the security™s total return for an agreed rate on the relevant cash
amount
3. on the swap™s maturity date the institution repurchases the security for
the market price

In theory, each leg of the transaction can be executed separately with
different counterparties; in practice, the trade is bundled together and so
is economically identical to a repo.
136 THE GLOBAL MONEY MARKETS



THE UNITED KINGDOM GILT REPO MARKET
Trading in UK gilt repo market began on January 2, 1996. Prior to this,
securities lending in the gilt market was available only to gilt-edged
Market Makers (GEMMs), dealing through approved intermediaries,
the Stock Exchange Money Brokers (SEMBs).12 The introduction of
Gilt Repo allowed all market participants to borrow and lend gilts. The
market reforms also liberalized gilt securities lending by removing the
restrictions on who could borrow and lend securities, thus ensuring a
“level playing ¬eld” between the two types of transaction.
The market grew to about £50 billion of repos and securities lend-
ing outstanding in the ¬rst two months, further growth took it to nearly
£95 billion by February 1997, of which £70 billion was in repos. This
¬gure fell to about £75 billion by November 1998, compared with £100
billion for sterling certi¬cates of deposit (CDs). Data collected on turn-
over in the market suggest that average daily turnover in gilt repo was
around £16 billion through 1999.
Gilt repo has developed alongside growth in the existing unsecured
money markets. There has been a visible shift in short-term money mar-
ket trading patterns from unsecured to secured money. According to the
Bank of England, market participants estimate that gilt repo now
accounts for about half of all overnight transactions in the sterling money
markets. The repo general collateral (GC) rate tends to trade below the
interbank rate, on average about 10“15 basis points below, re¬‚ecting its
status as government credit. The gap is less obvious at very short maturi-
ties, due to the lower value of such credit over the short term and also
re¬‚ecting the higher demand for short-term funding through repo by
securities houses that may not have access to unsecured money.
The sterling CD market has grown substantially, partly because the
growth of the gilt repo and securities lending market has contributed to
demand for CDs for use as collateral. One effect of gilt repo on the money
market is a possible association with a reduction in the volatility of over-
night unsecured rates. Fluctuations in the overnight unsecured market
have been reduced since the start of an open repo market, although the
evidence is not conclusive. This may be due to repo providing an alterna-
tive funding method for market participants, which may have reduced
pressure on the unsecured market in overnight funds. It may also have
enhanced the ability of ¬nancial intermediaries to distribute liquidity.

12 Securities lending is defined as a temporary transfer of securities in exchange for
collateral. It is not a repo in the sense there is no sale or repurchase of securities. The
use of the desired asset is reflected in a fixed fee payable by the party temporarily
taking the desired asset.
137
Repurchase and Reverse Repurchase Agreements



EXHIBIT 8.6 Bloomberg Security Description Screen of a UK Gilt




Source: Bloomberg Financial Markets

To illustrate a gilt repurchase agreement, let us consider a UK gilt
dealer who purchases a 7.5% coupon gilt stock (in the UK bonds are
referred to as stocks) and needs ¬nancing overnight. Exhibit 8.6 pre-
sents a Bloomberg Security Description screen for this security. As
before, we will use Bloomberg™s RRRA screen to illustrate the transac-
tion in Exhibit 8.7. Suppose the face amount of the position is $1 mil-
lion and the note™s full price (i.e., ¬‚at price plus accrued interest) is
£1,163,491.80. Suppose the haircut is 2%. Accordingly, the collateral is
102% of the amount being lent. This percentage appears in the box
labeled “COLLATERAL” in the upper right-hand corner of the screen.
Accordingly, to determine the amount being lent, we divide the note™s
full price of £1,163,491.80 by 1.02 to obtain £1,140,678.04 which is
labeled “SETTLEMENT MONEY” located on the right-hand side of
the screen. Suppose the repo rate in this transaction is 3.9063%. Then,
the dealer would agree to deliver the gilt stocks for £1,140,678.24 and
repurchase the same securities for £1,140,800.32 the next day. The
£122.08 difference between the “WIRED AMOUNT” of £1,140,678.24
and the “TERMINATION MONEY” of £1,140,800.32 is the sterling
interest on the ¬nancing. Using a repo rate of 3.9063% and a repo term
of 1 day, the sterling interest is calculated as shown below:
138 THE GLOBAL MONEY MARKETS



EXHIBIT 8.7 Bloomberg Repo/Reverse Repo Analysis Screen of a UK Gilt Repo




Source: Bloomberg Financial Markets

£122.08 = £1,140,678.24 — 0.039063 — (1/365)

This calculation agrees with repo interest as calculated in the upper
right-hand corner of Exhibit 8.7. Note that the day count convention in
the UK money markets is Actual/365.

Market Structure
The UK market structure comprises both gilt repo and gilt securities
lending. Some institutions will trade in one activity although of course
many ¬rms will engage in both. Although there are institutions which
undertake only one type of activity, there are many institutions trading
actively in both areas. For example, an institution that is short a particu-
lar gilt may cover its short position (which could result from an either an
outright sale or a repo) in either the gilt repo or the securities lending
market. Certain institutions prefer to use repo because they feel that the
value of a special bond is more rapidly and more accurately re¬‚ected in
the repo than the stock lending market.
Some ¬rms have preferred to remain in securities lending because their
existing systems and control procedures can accommodate stock lending
139
Repurchase and Reverse Repurchase Agreements



more readily than repo. For example, a ¬rm may have no cash reinvest-
ment facility or experience of managing interest rate risk. Such a ¬rm will
prefer to receive collateral against a bond loan for a fee, rather than inter-
est bearing cash in a repo. They may also feel that their business does not
need or cannot justify the costs of setting up a repo trading facility.
In addition, securities lending has bene¬ted from securities houses
and banks who trade in both it and repo; for example, borrowing a
bond in the lending market, repoing this and then investing the cash in
say, the CD market. Other ¬rms have embraced repo due, for instance
to the perception that value from a bond on special is more readily
obtained in the repo market than in the lending market.

Market Participants
Virtually from the start of the market, some ¬rms have provided what is
in effect a market making function in gilt repo. Typical of these are the
former SEMBs and banks that run large matched books. According to
the Bank of England, during 1999 there were approximately 20 ¬rms,
mostly banks and securities houses, which quoted two-way repo rates
on request, for GC (general collateral), speci¬cs and specials, up to three
months. Longer maturities are also readily quoted. Examples of market
making ¬rms include former SEMBs such as Lazards, Cater Allen (part
of the Abbey National group), and Rowe & Pitman (part of the UBS
group), and banks such as RBS Financial Markets, HSBC, Deutsche
Bank, and Barclays Capital. Some ¬rms will quote only to their own cli-
ents. Many of the market making ¬rms quote indicative repo rates on
screen services such as Reuters and Bloomberg. Exhibit 8.8 presents a
Bloomberg screen of repo rates in UK markets on November 13, 2001
for various maturities out to one year.
A number of sterling broking houses are active in gilt repo. Counter-
parties still require signed legal documentation to be in place with each
other, along with credit lines, before trading can take place, which is not
the case in the interbank broking market. A gilt repo agreement is not
required with the broker, although ¬rms will certainly have counterparty
agreements in place with them. Typical of the ¬rms providing broking ser-
vices are Garban ICAP, Tullet & Tokyo, and King & Shaxson Bond Bro-
kers Limited, part of Old Mutual plc. Brokers tend to specialize in
different aspects of the gilt market. For example, some concentrate on GC
repo, and others on specials and speci¬cs; some on very short maturity
transactions, and others on longer term trades. Brokerage is usually 1
basis point of the total nominal amount of the bond transferred for GC,
and 2 basis points for speci¬c and special repo. Brokerage is paid by both
sides to a gilt repo.
140 THE GLOBAL MONEY MARKETS



EXHIBIT 8.8 Bloomberg Screen of UK Repo Rates




Source: Bloomberg Financial Markets

The range of participants has grown as the market has expanded. The
overall client base now includes banks, building societies, overseas banks
and securities houses, hedge funds, fund managers (such as Standard Life,
Scottish Amicable, and others), insurance companies, and overseas cen-
tral banks. Certain corporates have also begun to undertake gilt repo
transactions. The slow start in the use of tri-party repo in the UK market
has probably constrained certain corporates and smaller ¬nancial institu-
tions from entering the market. Tri-party repo would be attractive to such
institutions because of the lower administrative burden of having an
external custodian. The largest users of gilt repo will remain banks and
building societies, who are required to hold gilts as part of their Bank of
England liquidity requirements.

Bank of England Open Market Operations
The Bank of England introduced gilt repo into its open market opera-
tions in April 1997. The Bank aims to meet the banking system™s liquid-
ity needs each day via its open market operations. Almost invariably the
market™s position is one of a shortage of liquidity, which the Bank gener-
ally relieves via open market operations conducted at a ¬xed of¬cial
141
Repurchase and Reverse Repurchase Agreements



interest rate. The Bank™s repo operation in this case is actually a reverse
repo. The Bank will reverse in gilts and eligible Bills. The reason central
banks choose repo as the money market instrument to relieve shortages
is because it provides a combination of security (government debt as col-
lateral) and liquidity to trade in large size.



APPENDIX: SELECTED PARAGRAPHS FROM THE BOND MARKET
ASSOCIATION MASTER REPURCHASE AGREEMENT

1. Applicability
From time to time the parties hereto may enter into transactions in which
one party (“Seller”) agrees to transfer to the other (“Buyer”) securities or
other assets (“Securities”) against the transfer of funds by Buyer, with a
simultaneous agreement by Buyer to transfer to Seller such Securities at a
date certain or on demand, against the transfer of funds by Seller. Each
such transaction shall be referred to herein as a “Transaction” and, unless
otherwise agreed in writing, shall be governed by this Agreement, includ-
ing any supplemental terms or conditions contained in Annex I hereto and
in any other annexes identi¬ed herein or therein as applicable hereunder.

2. De¬nitions
(a) “Act of Insolvency”, with respect to any party, (i) the commence-
ment by such party as debtor of any case or proceeding under any
bankruptcy, insolvency, reorganization, liquidation, moratorium,
dissolution, delinquency or similar law, or such party seeking the
appointment or election of a receiver, conservator, trustee, custo-
dian or similar of¬cial for such party or any substantial part of its
property, or the convening of any meeting of creditors for purposes
of commencing any such case or proceeding or seeking such an
appointment or election, (ii) the commencement of any such case
or proceeding against such party, or another seeking such an
appointment or election, or the ¬ling against a party of an applica-
tion for a protective decree under the provisions of the Securities
Investor Protection Act of 1970, which (A) is consented to or not
timely contested by such party, (B) results in the entry of an order
for relief, such an appointment or election, the issuance of such a
protective decree or the entry of an order having a similar effect, or
(C) is not dismissed within 15 days, (iii) the making by such party
of a general assignment for the bene¬t of creditors, or (iv) the
admission in writing by such party of such party™s inability to pay
such party™s debts as they become due;
142 THE GLOBAL MONEY MARKETS



(b) “Additional Purchased Securities”, Securities provided by Seller to
Buyer pursuant to Paragraph 4(a) hereof;

(c) “Buyer™s Margin Amount”, with respect to any Transaction as of any
date, the amount obtained by application of the Buyer™s Margin Per-
centage to the Repurchase Price for such Transaction as of such date;

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