LO 51.1: Describe the mechanics of repurchase agreements (repos) and calculate

LO 51.1: Describe the mechanics of repurchase agreements (repos) and calculate the settlement for a repo transaction.
Economically, a repurchase agreement (i.e., repo) is a short-term loan secured by collateral. Mechanically, it is a contract between two parties where one party sells a security at a specified price with a commitment to buy back the security at a future date at another specified (higher) price. The difference between the sell and buy prices of the security is the implied interest (i.e., return) on the transaction. Repos are used by both borrowers needing short-term funds and by lenders needing short-term investments or access to hard-to-find collateral.
The term repo refers to the transaction from the borrowers side; that is, from the side that sold the security with a promise to buy it back. When we examine the same transaction from the lender’s side, the transaction is referred to as a reverse repurchase agreement (i.e., reverse repo). Figures 1 and 2 illustrate an example of a repo trade.
Figure 1: Repo Initiation
$10 million face value ABC bond
Counterparty A
Counterparty B
$ 11,000,000
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
Suppose that on May 1, counterparty A wishes to borrow $11 million for 31 days. It therefore sells ABC bonds with a face value of $10 million and a market value of $11 million to counterparty B, with a contract price of $11 million to reflect the bonds market value. Concurrently, counterparty A agrees to buy back the bond in 31 days at the contract price plus 0.3% interest (30 basis points).
Professors Note: Interest rates fo r repos are always quoted at an annualized rate, and the convention fo r most money market securities is to use an actual/360 day count.
The repurchase price in this example is computed as follows:
/
$11,000,000 x 1+
\
0.3% x31
360
,
$11,002,841.67
As illustrated in Figure 2, on the June 1 termination of the repo trade, counterparty A will purchase back the $10 million face value ABC bond for $11,002,842.
Figure 2: Repo Termination (Settlement)
Counterparty A
$ 10 million face value ABC bond
<——————- ——————-
$11,002,842
Counterparty B