In a repo transaction, the cash borrower pays an interest in repo rate for borrowing the cash. On the other hand, the cash lender gets a bond as collateral. In this transaction, it looks like the cash lender gets a bond as well as an interest payment. He ends up in a long position in a bond without any financing cost (instead with a repo interest as income). this seems to be contradict to what people say “financing cost for bond is repo rate” . can someone please explain to me where my confusion comes from please ?
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$\begingroup$ I got a feeling myself the confusion is coming from the poor understanding of the repo market. probably because cash lender actually has no position in the bond even though keeps the bond during the repo transaction ? it is the cash borrower that is in a long position of the bond as he agrees to buy the bond back with a pre-determined price. $\endgroup$– PeacefulCommented Jun 28, 2018 at 6:02
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$\begingroup$ Your comment's basically correct. The borrower bears all the bond risk, and has to post margin should the bond collateral deteriorate vs the cash liability. The lender bears credit risk to the borrower, but collateralisation normally covers this unless borrower and bond are highly correlated and repo term is long (eg 5y repo lending to eg a spanish bank against an SPGB) - in which case higher collateralisation using IA (independent amount) in addition to VM (variation margin) may be entailed $\endgroup$– MehnessCommented Jun 28, 2018 at 8:45
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$\begingroup$ Put another way, what ever happens, the borrower has to pay back say 100 at maturity and gets back the bond, whatever its value (even if recovery), so if the borrower doesn't default the lender just gets back the cash they lent. Even any intervening bond coupons go to the borrower, they absolutely do just have a financed long position in the bond $\endgroup$– MehnessCommented Jun 28, 2018 at 8:58
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$\begingroup$ (and obviously by maturity in previous I meant the repo maturity/term not necessarily the bond maturity!) $\endgroup$– MehnessCommented Jun 28, 2018 at 9:14
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$\begingroup$ thanks for the comments. I thought it is the cash lender that has the legal entitlement of the bond. i.e., the cash lender would get the dropped coupon if there is one $\endgroup$– PeacefulCommented Jun 28, 2018 at 21:40
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1 Answer
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In repo terminology the bid (buyside) is for the collateral, i.e. if one bids repo then one bids for the bonds. And if one offers repo, one owns the bonds and wants to lend the collateral for cash. (Note your question was phrased the other way around in terms of cash and I am trying to lean you toward more regularly used trading terminology.)
This resource [ https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/ ], is very good for answering generic questions on repo.
Semantically, across different jurisdictions, a repo transaction is just a committed buy and sell-back deal. One commits to a buy price on a certain date and simultaneously commits to sell the bonds back on a future date.
How are the buy and sell back prices determined?
The seller of bonds (repo offer) recognises that she loses the right to the bond coupon for the intermittent period, so she adjusts (in her favour) the buy and sellback prices to recover this lost coupon interest - effectively she mechanically maintains financial benefit of the coupon. But she recognises that she has been loaned cash for the period and owes interest on it so adjusts (adversely to her) the buy and sellback prices to include cash interest payment. You will observe that this negative adjustment is calculated from the repo rate, so the true financing cost is the same as the repo rate.
Hopefully you will observe that you should not be able to arbitrage any profit under this scheme. If you buy bonds in the market, sell them on repo to acquire cash for the purchase then buy them back later under the repo and sell them in the market to release cash, you are back where you started and should not have made an expected profit or a loss. However, the final sale price in this scenario is key and subject to market movement, and therefore even if you sell bonds on repo you maintain the financial exposure, or delta risk, to those bonds.
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$\begingroup$ @PeacePanda helpful to accept the answer if you believe it to be satisfactory. Usually I wait to see if anymore answers come in on my own questions but looks like this question is now exhausted.. $\endgroup$– Attack68 ♦Commented Jun 29, 2018 at 17:32
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$\begingroup$ was string to accept it but could not find a button to do so... I am new to this system but would think it should be more apparent... $\endgroup$– PeacefulCommented Jul 7, 2018 at 6:10
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$\begingroup$ Hi @Attack68, let say I sold the bond for 100€, the bonds is intended to pay a 5€ coupon during the repo period. Hence the buy-back price should be 95€ to compensate the lost coupon. But what if the default occurred before the coupon payment ? Let say the recovery is 50€. So If I have kept the bond I would lost 50€. But in the repo transaction I lost only 45€. My question is how the buy-back price is calibrated to avoid such situation ? $\endgroup$– JiemCommented Aug 5, 2018 at 12:59
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$\begingroup$ Probability of default is factored into the price of the bond as an investment. A repo is a committed collateralised buy and sell back, so if the bond defaults the buy/sell prices are still honoured and therefore the default only affects the underlying holder of the asset, but is not a consideration of the repo. Indirectly, it is a concern because the market value of a defaulted bond will decline considerably reducing its effect as worthwhile collateral. Hence the haircut of bonds which have potentially higher volatility is necessarily higher as effective insurance. $\endgroup$– Attack68 ♦Commented Aug 5, 2018 at 13:19