Fixed Income I
Reading 43. Fixed-Income Markets: Issuance, Trading, and Funding
Learning Outcome Statements
h. describe short-term funding alternatives available to banks;
i. describe repurchase agreements (repos) and the risks associated with them.
CFA Curriculum, 2020, Volume 5
Subject 5. Short-Term Funding Alternatives Available to Banks
- Retail deposits: checking accounts, savings accounts, money market accounts, etc.
- Central bank funds: funds available from the central bank, or from other banks in the central bank funds market
- Interbank funds: the market of loans and deposits between banks
- Large denomination negotiable certificates of deposit: non-negotiable or negotiable CDs, large-denomination CDs or small denomination CDs
A repurchase agreement 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. It is actually a collateralized loan. The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan. The implied interest rate is called the repo rate.
A loan for one day is called an overnight repo. A loan for more than one day is called a term repo. If a repo agreement lasts until the final maturity date, it is known as a "repo to maturity."
The repo rate is lower than the cost of bank financing. It is a function of a few factors, including the risk associated with the collateral, the term of the repo, the delivery requirement for the collateral, the supply and demand conditions of the collateral, and the interest rates of alternative financing in the money market. The more difficult it is to obtain the collateral, the lower the repo rate. Hot collateral or special collateral is collateral that is highly sought-after by dealers and can be financed at a lower repo rate than general collateral.
From a dealer's perspective, if it is lending cash, the repo is then referred to as a reverse repurchase agreement.
Credit risks are faced by both parties. The difference between the market value of the security used as collateral and the value of the loan is the repo margin. It is most likely to be lower when:
- The maturity of the repo is short.
- The quality of the collateral is high.
- The credit quality of the counterparty is high.
- The underlying collateral is in short supply or there is a high demand for it.
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Confirm: harder to collaterize means LOWER repo rate?? Seems counterintuitive.
The more difficult it is to obtain the collateral, the lower the repo rate.
What they mean by "the more difficult it is to obtain the collateral" is that the collateral referenced is in high demand, so therefore cheaper funding.
The borrower (or the seller of the collateral) has a security that lenders of cash want, for whatever reason. The party that needs the hot collateral will be willing to lend funds at a lower repo rate so as to obtain the collateral.
Why do lenders want to have that collateral if they will sell it back to the original owner anyway?
To make money, I believe.
Harder to obtain collateral = less subject to value fluctuation over time = more secure form of collateral = lower rate
<<<<< dbedford got it !
The more difficult it is to obtain the collateral, the lower the repo rate