Understanding Repurchase Agreements | CFA Level I

Today, we’re diving deep into the world of short-term financing, focusing on a fascinating instrument known as the repurchase agreement, or repo for short.

What is a Repurchase Agreement?

In simple terms, a repurchase agreement involves two parties: one looking to raise funds by selling securities with a promise to buy them back later, and the other providing cash against those securities. Think of it as a short-term loan, where the securities serve as collateral.

Here’s how it works:

• The seller (cash borrower) sells securities to the buyer (cash lender).
• They agree on a repurchase date when the seller buys back the securities.
• The price difference between selling and buying back equals the interest earned by the lender.

Repos can last from a single day (overnight repo) to several days or weeks (term repo), offering flexibility in financing terms.

Factors Influencing the Repo Rate

The repo rate can be affected by several factors:

• Repo term length: Longer terms usually mean higher rates.
• Collateral quality: Higher quality collateral often leads to lower rates.
• Collateral demand: High-demand securities can reduce the repo rate.
• Collateral delivery: Physically delivered collateral might secure a lower rate.

Understanding Initial Margin and Haircut

Initial margin and haircut are critical in setting the terms of a repo. The initial margin ensures the lender is protected against the borrower’s default, while the haircut provides a discount to cover potential losses.

Now, let’s map out a repo’s life from initiation to repurchase, highlighting the importance of maintaining the initial margin ratio and how variation margin plays into this equation.

EXAMPLE

A local bank needs to borrow $1M for 30 days using 10-year sovereign bonds as collateral. With a 1.5% repo rate and a 101% initial margin, they need to pledge 10,100 bonds and repurchase them for $1,001,250 after 30 days.

If the bond prices rise to 100.5 per $100 par nine days in, the bank must adjust the collateral to maintain the initial margin ratio, showcasing the dynamic nature of repo agreements.

The Repo Rate

The interest rate implied in a repo is called the repo rate, which is the annualized percentage difference between the repurchase and selling prices.

Repo rate = Repurchase price / Selling price – 1

Repos are popular because their interest cost is usually lower than the rate on bank loans or other short-term borrowing.

Reverse Repurchase Agreement: The Other Side of the Coin

When viewed from the perspective of the security buyer or the cash lender, this arrangement is termed a reverse repurchase agreement. In this scenario, the lender provides cash by buying securities and earns interest by selling them back on the repurchase date.

Benefits of Reverse Repos

• Security and Liquidity: For lenders, reverse repos offer a secured short-term investment, minimizing liquidity and default risk.
• Return Opportunities: Investors can tailor returns by adjusting the repo term length or by dealing with varying qualities of collateral.

Risks in Repurchase Agreements

While repos are generally considered low-risk, several factors can elevate risk levels:

• Default Risk: The possibility of borrower default can lead to challenges in liquidating the collateral.
• Margining Risk: Fluctuations in collateral value may require additional collateral that the counterparty cannot provide.
• Legal Risk: Enforcing rights under a repurchase agreement can sometimes be complex.
• Rollover Risk: Borrowers face risks when they cannot rollover the agreement under unfavorable market conditions.

Managing Risks and Triparty Repos

To mitigate these risks, participants sometimes involve a third-party agent, leading to what is known as a triparty repo. These agents can streamline the process, though they don’t eliminate the inherent credit risk.

The Role of Triparty Agents

Triparty agents act as custodians, facilitating the efficient transfer of securities and interest payments between the borrower and lender. This arrangement can offer cost efficiencies and access to a broader collateral pool.

Conclusion

Repurchase agreements represent a cornerstone of short-term financial market liquidity. By understanding the mechanics, benefits, and risks associated with repos and reverse repos, financial professionals can navigate these instruments more effectively.