# LO 31.7: Calculate the financing advantage of a bond trading special when used in

LO 31.7: Calculate the financing advantage of a bond trading special when used in a repo transaction.
The premium trading value of OTR bonds is due both to their liquidity and financing advantage as we previously discussed. The liquidity advantage stems from the ability to sell these bonds quickly for cash. The financing value stems from the ability to lend the bonds at a cheap special rate and use the cash to lend out at higher GC rates. This financing value is dependent on the traders expectation of how long the bond will continue trading at its special rate before the rate moves higher toward the GC rate.
Lets assume that an OTR bond is issued on January 1 and trades at a special spread of 0.18%. A trader expects the bond to trade at GC rates past March 31. The financing value of the OTR bond is therefore the value over 90 days. The value of \$100 of cash at the spread of 0.18% is:
90×0.18% _ _ \$100 x ————– — \$0,043
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Thus, the financing value is 4.3 cents per \$100 market value of the bond
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
K e y C o n c e pt s
LO 51.1 Repurchase agreements, or repos, are bilateral contracts where one party sells a security at a specified price with a commitment to buy back the security at a future date at a higher price. From the perspective of the borrower we refer to repos, while from the perspective of the lender we refer to reverse repos. Repos are valued based on a simple time value of money calculation.
LO 51.2 >From the perspective of the borrower, repos offer relatively cheap sources of obtaining short term funds. Balancing the cost of funding (e.g., through repos) and other sources of funds (including potentially no funding) is called liquidity management.
>From the perspective of the lender, repos can be used for either investing (cash management) or for financing purposes (e.g., to finance short bond positions).
LO 51.3 Repos give rise to both counterparty risk and liquidity risk. Counterparty (credit) risk is the risk of borrower default or non-payment of its obligations. Liquidity risk is the risk of an adverse change in the value of the collateral. Counterparty risk is mitigated with collateral, while liquidity risk is mitigated with haircuts, margin calls, shorter repo terms, and higher quality collateral.
LO 51.4 During the recent financial crisis, lenders were increasingly demanding higher quality collateral and larger haircuts and even withdrew liquidity altogether. Borrowers experienced collateral liquidations and capital declines, leading to several high profile company failures and bankruptcies. The failures of Bear Stearns and Lehman Brothers illustrate these events.
LO 51.5 Repo trades can be secured either with general collateral or with specific collateral. Lenders (as investors) in general collateral (GC) repo trades are not concerned with receiving a specific security, and only the broad categories of acceptable securities are specified. GC trades suit investors in repos because they can obtain the highest repo rate for the collateral received. Lenders (as financing participants) in special collateral repo trades (specials trades) are concerned with receiving a particular security as collateral. The particular security received can then be used to finance the purchase of a bond (for shorting) or to finance its inventory or proprietary positions.
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
LO 51.6 The difference between the GC rate and the special rate for a particular security and term is called a special spread. Special spreads are tied closely to Treasury bond auctions, and the level and volatility of the spread can be an important gauge of market sentiment. Special spreads are generally narrower immediately after an auction, but widen before auctions. Spreads generally move within a band that is capped at the GC rate (implying a floor of 0% for the special rate).
Following the recent financial crisis, regulators adopted a penalty rate for failed trades at the greater of 3% minus the federal funds rate, or zero. As a result, the penalty rate becomes the new upper limit for the special spread.
LO 31.7 The financing value of the bond is the ability to lend the bonds at a relatively cheap special rate and use the cash to lend out at higher GC rates. This financing value is dependent on the traders expectation of how long the bond will continue trading at its special rate.
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
C o n c e pt C h e c k e r s
1.
3.
Pasquini Investments (Pasquini) is a private brokerage looking for 30-day financing of \$23 million of its accounts payable but is unsure whether the appropriate investment is a term repurchase agreement (repo) or a term reverse repo agreement. Pasquini is willing to post AAA-rated government bonds as collateral. The bonds have a face value of \$27 million and a market value of \$23 million. The firm is quoted a rate of 0.5% for the transaction. Which of the following choices most accurately reflects the contract type and the contract price needed by Pasquini?
Contract tvpe
A. Repo B. Reverse repo C. Repo D. Reverse repo
Contract price \$27,011,250 \$25,010,417 \$25,010,417 \$27,011,250
Posting collateral and requiring collateral haircuts are important risk mitigants in repo transactions with respect to which of the following risks?
Posting collateral
A. Market risk B. Credit risk C. Market risk D. Credit risk
Collateral haircuts Interest rate risk Interest rate risk Liquidity risk Liquidity risk
Kotra Bank Holdings, Inc., (Kotra) is currently weighing the cost of its funding against the risk of being left without financing. The term that best describes Kotras activities is: A. counterparty (credit) risk. B. specials trading. C. D. overnight funding.
liquidity management.
4.
In a presentation to management, a bond trader makes the following statements about repo collateral:
Statement 1: The difference between the federal funds rate and the general collateral rate is the special spread.
Statement 2: During times o f financial crises, the spread between the federal funds rate and the general collateral rate widens.
Which of the traders statements are accurate? A. Both statements are incorrect. B. Only Statement 1 is correct. C. Only Statement 2 is correct. D. Both statements are correct.
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
The latest on-the-run (OTR) Treasury bond issued on March 1 is trading at a special spread of 0.25%. Traders expect the bond to trade at general collateral (GC) rates past June 30. The financing value of the OTR bond is therefore the value over 122 days. Given this information, the value of lending \$100 of cash is closest to: A. \$0,085. B. \$0,250. C. \$0,305. D. \$0,847.
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
C o n c e pt C h e c k e r A n sw e r s
1. C Given that Pasquini is a borrower in the repo market, the transaction is a repo from the
perspective of the firm (but a reverse repo from the perspective of the lender). The contract price is calculated as follows: \$25,000,000 x 1 + 0.5% x 30 ,
\$25,010,417
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2. D Collateral is an important counterparty credit risk mitigant. Repo loans are secured by
collateral, which makes the lender much less vulnerable to a decline in the creditworthiness of the borrower. Collateral haircuts are important in mitigating liquidity risk in repo transactions. The lender is exposed to the risk of the value of the collateral declining during the repo term, which can be mitigated by requiring (higher) haircut values, that is, discounts to the value of the posted collateral.
3. C The process of weighing the cost of its funding against the risk of being left without
financing is called liquidity management. Counterparty (credit) risk is the risk of borrower default or non-payment of its obligations. In specials trading, a lender of cash initiates a repo trade in order to receive a particular security (special collateral). Overnight funding refers to borrowing and lending in the overnight market.
4. C The traders first statement is incorrect. The difference between the federal funds rate and
the general collateral (GC) rate is known as the fe d funds- GC spread. The special spread is the difference between the GC rate and the special rate for a particular security.
The trader s second comment is correct. During times of financial crises, the spread between the federal funds rate and the general collateral rate widens as the willingness to lend Treasury securities declines, lowering the GC rate (thereby increasing the spread).
5. A The financing value of \$100 of cash at a spread of 0.25% is calculated as:
\$100x—————-= \$0.0847 or 8.47 cents
360
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Est i ma t i n g Li q u i d i t y Ri s k s
Topic 52
E x a m F o c u s
This topic addresses the calculation of liquidity cost and applies this value to the value at risk measure. We will see how to compute liquidity-adjusted VaR (LVaR) when considering both a constant spread and an exogenous spread approach. Be familiar with how to make these calculations, particularly for the constant spread approach. Also, understand the concept of cash flow at risk (CFAR) and how liquidity is impacted during a crisis.
L i q u i d i t y R i s k