From my understanding, a classic repo is an agreement for one party to get cash by placing collateral at a certain price and then get the collateral back at maturity by paying the initial cash plus repo interest.

Say, 1m nominal of bond (dirty price 105%) are placed. Then party A receives 1.05m in exchange for the bond. Let the term repo be for 30 days, with repo rate 6%. Then party A will then pay 1.05m*(1+6%*30/360) = 1,055,250 to party B to get the bond back.

My problem comes when I have to mark the repo to market. How is this done? Do we just discount the termination amount to the value date? Do we take the market value of the collateral (the bond) into account when valuing the repo?

You are right in that in repo, one sells a collateral to another party and agrees to repurchase it at a fixed price in the future, and is essentially a collateralised borrowing. The difference between the fixed repurchase price and the initial sale price is essentially interest (repo rate), and is calculated using money market conventions as repos are usually short dated transactions.

However, the initial cash would be based on the market value of the collateral, and usually the lender would apply a hair cut, say 2% so you get cash of 98% of the market value of the collateral. The repurchase price would be calculated based on this initial cash, so you will pay interest on what you borrowed. The haircut is to protect the lender in case the value of the collateral declines, or to reflect any other risks associated with the collateral such as illiquidity, wrong way risk etc. In exchange cleared transaction, intial margin plays similar role.

In terms of mark to market value, it depends on the perspective but general principles are the same. The value of the collateral is its current market value, including any accrued interest/coupon etc as seller would be receiving any coupons paid during the life of the repo. The value of the cash leg is just initial cash plus accrued repo interest for simple calculations. For more accurate valuation, you can take the terminal value and discount it at the then market repo rate as an alternative. You have locked the interest at the rate agreed at the time of the transaction, but today rate could be different. I ignored counterparty risk etc, though you might need to take these into accounts for full valuation- e.g., the 2% haircut is unsecured lending to the counterparty?

Hope this helps.

  • 1
    Thanks, Magic! I was of the notion that the collateral would not factor anywhere in the valuation of the repo since it's just a ring-fenced asset that is held against the loan. I thought that the MtM value of the collateral only comes into play when the collateral loses value and more of it needs to be posted. – nemesis94 Oct 11 at 20:51
  • Depends on the purpose of valuation but you do own the price risk of the collateral as you are going to get it back at maturity. Yes changes in value would trigger calls. – Magic is in the chain Oct 11 at 21:15

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