LO 31.2: Explain common motivations for entering into repos,

LO 31.2: Explain common motivations for entering into repos, in cash management and liquidity management.
including their use
B o r r o w e r s i n R e p o s
>From the perspective of the borrower, repos offer relatively cheap sources of obtaining short term funds. Relative to unsecured borrowing, repos allow the borrower to obtain funds at favorable rates because lenders are willing to accept lower returns (relative to unsecured transactions) in favor of the security of collateral.
Bond Financing
Repos can also be used to obtain cash to finance a long security position. Consider a financial institution in the previous example (as counterparty A) that just purchased the same $10 million face value ABC bond from a client in hopes of selling it to another investor for a profit. Until the new buyer is found, however, the financial institution needs to finance the purchase of the bond. It can do so by borrowing cash through an overnight repo trade (from counterparty B) and pledging the ABC bond as collateral, subject to any applicable haircuts. If the financial institution cannot immediately find a buyer, it needs to roll/renew its position. If the initial repo trade and the subsequent rolls are transacted with the same counterparty, the trade flow is similar to Figure 1.
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
If the repo is renewed/rolled with a different counterparty, the financial institution first needs to unwind the initial trade (with counterparty B) and then enter into a new repo trade with another counterparty (counterparty C). This is illustrated in Figure 3.
Similar to financing a bond purchase, the financial institution may also use repos to finance proprietary positions or to finance its inventory in order to make markets.
Figure 3: Back-to-Back Repo Trades
$ 10 million face value ABC bond
$ 10 million face value ABC bond
Counterparty C
From the perspective of the lender, repos can be used for either investing or for financing purposes as part of an entitys cash management or financing strategies.
Cash Management (Repos as Investment Vehicles)
Lenders use repos (taking the reverse repo side) for investing when they hold cash either for liquidity or safekeeping reasons and need short-term investing opportunities to generate return on their surplus cash position. For example, money market mutual funds hold cash for safekeeping on behalf of investors and therefore need low risk, short maturity investments to generate return rather than holding idle cash. Municipalities, on the other hand, have significant surplus cash generated from tax revenues. Municipalities are prohibited from investing in high-risk investments, and repos offer a low risk, collateral- secured investment opportunity.
Investors look for liquidity and tend to favor very short-term positions in overnight repos, which provide significant flexibility to the investor. Following each overnight repo
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
transaction, the investor could re-evaluate its decision whether to continue lending cash. Investors may also transact in open repos by lending for a day under a contract that renews each day until it is canceled. Repos could have longer maturities out to several months, although typically the longer the maturity, the lower the overall demand.
In addition to liquidity, investors also prefer higher quality collateral. Repo collateral is generally limited to high-quality securities, including securities issued or guaranteed by governments and government-sponsored entities. Because the lender is faced with the risk of a decline in collateral value during the term of the repo transaction, repo agreements often require collateral haircuts. A haircut refers to discounting the value of the collateral posted in relation to its risk. In our earlier repo trade example, counterparty B may only lend $10.5 million against the $11 million market value of the ABC bond collateral received. Finally, repo transactions are also subject to margining and (daily) margin calls. A margin call requires a borrower to post additional collateral in a declining market, but it also allows the borrower to withdraw excess collateral in up markets.
Short Position Financing (Repos as Financing Vehicles)
Lenders may also use repos (as the reverse repo side) to finance short positions in bonds. Consider an investment management firm that has a view that interest rates will rise and bond prices will fall. It can take advantage of this view by obtaining the desired bond collateral through lending cash in a reverse repo trade. It would then short sell the bond received through the reverse repo and buy it back at the market price at a later date, hoping to benefit from the trade from a fall in prices. The transaction flows would be similar to what we previously illustrated in Figure 1 and Figure 2, with the investment management firm as counterparty B.
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