Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 14. Repurchase Agreements and Financing

Presented by: Sudhanshu

Module 1. Mechanics of Repos, Repo Motivations, and Counterparty and Liquidity Risk

Module 2. Recent Credit Crisis, Collateral and Special Spread

Module 1. Mechanics of Repos, Repo Motivations, and Counterparty and Liquidity Risk

Topic 1. Mechanics of Repurchase Agreements

Topic 2. Borrowers in Repos

Topic 3. Lenders in Repos

Topic 4. Counterparty Risk and Liquidity Risk

Topic 1. Mechanics of Repurchase Agreements

A repurchase agreement (repo) is a bilateral contract where one party sells a security with a commitment to buy it back at a future date at a higher price. From the perspective of the borrower, it's a repo; from the perspective of the lender, it's a reverse repo. Economically, it is a short-term, secured loan valued based on a simple time value of money calculation.

• Settlement Calculation: The repurchase price is calculated using the initial loan amount, the annualized repo rate, and the days to maturity. Repo rates typically use an actual/360-day count.

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• Example: For a $\$11,000,000$ loan over 31 days at a $0.3\%$ annual rate, the repurchase price would be:

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Practice Questions: Q1

Q1. Pasquini Investments (Pasquini) is a private brokerage looking for 30-day financing of $25 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 $25 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?

Practice Questions: Q1 Answer

Explanation: C is correct.

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:

Topic 2. Borrowers in Repos 

From the borrower's perspective, repos offer a relatively cheap source of obtaining short-term funds on a secured basis. This is a key part of liquidity management, where firms balance the cost of funding from different sources, including repos, against the risk of having no funding at all.

• Financing Long Positions: Firms can use repos to finance a long security position. For example, a financial institution that purchases a bond with the hope of selling it for a profit can use an overnight repo to finance that position. If the bond isn't sold by the next day, the borrower must "roll" the repo.

• Balancing Funding Costs: Repos are an important funding source for dealers to finance proprietary positions and to hold inventory for market making. The cost of repo financing is lower than unsecured loans because collateral is provided, which lowers the credit risk for the lender.

Topic 3. Lenders in Repos 

• From the lender's perspective (reverse repo), repos can be used for either investing (cash management) or for financing purposes.

  • Cash Management: Lenders like money market mutual funds, municipalities, and corporations with surplus cash use reverse repos to invest these funds. Repos offer a short-term, low-risk, collateral-secured investment opportunity.

  • Financing Purposes: A lender can use a reverse repo to obtain a specific security (e.g., to finance a short bond position). For example, a trader who has sold a bond short but doesn't own it can obtain the bond via a reverse repo. This strategy depends on the trader deciding whether the value of obtaining that specific security is worth accepting a lower repo rate.

  • Risk Mitigation: Lenders protect against declines in collateral value using collateral haircuts. A haircut is a discount applied to the collateral's market value when determining the loan amount (e.g., lending $\$10.5$ million against collateral with a market value of $\$11$ million). They also use margin calls to require the borrower to post additional collateral if the value of the original collateral falls during the repo term.

Topic 4. Counterparty Risk and Liquidity Risk

• Repo transactions are not risk-free and give rise to both counterparty and liquidity risks.

  • Counterparty Risk: Also known as credit risk, this is the risk of the borrower defaulting or non-payment of the loan. This is a lower risk in repos compared to unsecured loans because the lender holds collateral that can be sold to recover the loan amount.

  • Liquidity Risk: This is the risk of an adverse change in the collateral's value or its illiquidity. This is a major concern for the lender. During market downturns, the lender may be unable to quickly and efficiently sell the collateral to recover their funds. The risk can be managed by:

    • Applying haircuts to the collateral.

    • Implementing margin calls to require additional collateral.

    • Shortening the repo term.

    • Accepting only high-quality collateral with stable value and strong market liquidity.

Practice Questions: Q2

Q2. Posting collateral and requiring collateral haircuts are important risk mitigants in repo transactions with respect to which of the following risks?

Practice Questions: Q2 Answer

Explanation: D is correct.

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 credit worthiness 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.

Practice Questions: Q3

Q3. 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 Kotra’s activities is:
A. counterparty (credit) risk.
B. specials trading.
C. liquidity management.
D. overnight funding.

Practice Questions: Q3 Answer

Explanation: C is correct.

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.

Module 2. Recent Credit Crisis, Collateral and Special Spread

Topic 1. Repos During the Credit Crisis

Topic 2. Collateral in Repo Transactions

Topic 3. Special Spreads and the Auction Cycle

Topic 4. Special Spreads and Rate Levels

Topic 1. Repos During the Credit Crisis

• The 2007–2009 financial crisis exposed the risks inherent in the repo market. During the crisis, lenders lost confidence in collateral quality and demanded higher-quality securities and larger haircuts, which led to a collapse in liquidity.

  • Lehman Brothers: JPMorgan Chase, acting as Lehman's tri-party repo agent, began to demand haircuts on intraday loans. JPMorgan argued that it was trying to mitigate its growing exposure to Lehman by demanding additional collateral, as the value and liquidity of the existing collateral were declining. The collapse of Lehman Brothers highlighted how a firm's repo financing can dry up quickly as a crisis progresses.

  • Bear Stearns: In March 2008, a "run on the bank" occurred when lenders, concerned about Bear Stearns's health, refused to roll over their repo trades. The firm's reliance on short-term secured financing through repos made it vulnerable to this rapid withdrawal of cash and a complete loss of confidence in the firm's collateral, ultimately leading to its collapse.

Topic 2. Collateral in Repo Transactions

• There are two main types of collateral used in repos:

  • General Collateral (GC): In a GC repo, the lender is indifferent to the specific security and is only concerned with receiving a broad category of acceptable securities, like U.S. Treasury bonds. The repo rate for these trades is called the GC rate. The GC rate for U.S. Treasury collateral is a key short-term interest rate, trading just below the federal funds rate. This spread between the two rates typically widens during periods of financial stress.

  • Special Collateral: When the lender requires a specific security for their own financing purposes (e.g., to finance a short bond position), it's a specials trade, and the collateral is special collateral. The repo rate for these trades is called the special rate. Lenders accept a lower special rate to obtain a security that is in high demand, such as an on-the-run Treasury bond.

Practice Questions: Q1

Q1. 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 of financial crises, the spread between the federal funds rate and the general collateral rate widens."

Which of the trader’s 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.

Practice Questions: Q1 Answer

Explanation: C is correct.

The trader’s first statement is incorrect. The difference between the federal funds rate and the general collateral (GC) rate is known as the fed 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 (there by increasing the spread).

Topic 3. Special Spreads and the Auction Cycle

• Special Spread: This is the difference between the GC rate and the special rate for a particular security and term. The spread is a key indicator of the demand for a specific security. A negative spread indicates the special rate is lower than the GC rate.

• On-the-Run (OTR) Issues: The most recently issued U.S. Treasury bond is the "on-the-run" (OTR) issue. OTR issues are highly liquid, which makes them desirable as special collateral and often results in a lower repo rate and a wider special spread. An example from the text shows an OTR bond trading at a special spread of 0.25%.

• Auction Cycle: Special spreads are closely linked to the U.S. government Treasury bond auction cycle. OTR special spreads are typically narrower immediately after an auction due to the new supply of the security, which increases its availability. They widen before an auction as the old OTR issue becomes scarcer and anticipation for the new OTR issue grows.

Topic 4. Special Spreads and Rate Levels

• Special spreads are generally capped by the GC rate.

  • Floor: The special rate has an effective floor of $0\%$. A trader would not borrow a bond at a negative rate. This puts an effective upper bound on the special spread at the GC rate.

  • Penalty Rate: Since 2009, a penalty rate for failed trades acts as the new upper limit for the special spread. The penalty rate is the greater of $3\%$ minus the federal funds rate, or zero.

  • Financing Advantage: The financing advantage of a bond trading special is the value gained from lending the bond at a cheap special rate and lending the cash out at a higher GC rate. The value is calculated as:

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Example: The value of lending $\$100$ of cash over 122 days with a special spread of $0.25\%$ is closest to:

Practice Questions: Q2

Q2. 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.

Practice Questions: Q2 Answer

Explanation: A is correct.

The financing value of $100 of cash at a spread of 0.25% is calculated as: