I appreciate what a repo/reverse repo transaction is, but I'm struggling to understand exactly how the cost of funding trades via repo works from a practical point of view for a bond trader.

Current understanding

  1. Going long: if a trader wants to go long, they finance the trade in the repo market by borrowing cash (via selling repo) which they can use to buy their desired bond. Hence buying a bond entails costs from borrowing cash to obtain securities.

  2. Going short: if a trader wants to go short, they obtain the security by lending cash via repo to obtain the security, which they can then sell onto another counterparty. Hence shorting a bond entails gains from lending cash at the repo rate.

In summary, going long results in funding costs because of repo, and going short results in gains because of repo.

Issues with (1)

Why do calculations for financing long positions of a security (call it security $A$) necessarily involve the repo rate for bond $A$? Could you not similarly use the repo rate of any other bond that the desk owns? In fact, it seems to me that you should use the repo rate of a different bond, since if you could use that bond to obtain cash via repo, you wouldn't need to buy it in the first place.

Issues with (2)

Where does the cash used to enter the initial repo transaction (the one via which the security is obtained) come from? If they have this cash to enter repo transactions to cover short positions, then why don't they just use this cash to go long rather than financing long positions via repo?

Desired answer

  1. Is my initial understanding of going long/short via repo correct?

  2. What about issues (1) and (2) is incorrect?

  3. Can you give a description of the transactions a bank undergoes in explaining where my misunderstanding lies?

  • $\begingroup$ I think the issue here is I'm thinking about the processes sequentially, when they should be considered simultaneously. With the sequential thinking it's not possible: you can't obtain cash by repoing out bond $A$, and then consequently use that cash to finance the purchase of bond $A$, because you didn't have bond $A$ for repo in the first place. However, you can simultaneously purchase bond $A$ and repo out bond $A$. Think this is where my issue is? $\endgroup$
    – quanty
    Commented Feb 28, 2021 at 23:22

1 Answer 1

  1. Yes. Repo trades are funding source for long bond, while reverse repo trades are security borrowing source for short bond.

  2. Issues 1. In reality, you cannot just fund your long bond A by repo trade with A only, because there will be haircut in repo. For example, you can only borrow 85% cash for high yield bonds, maybe 95% for investment, and 98% for treasury notes. Considering each bond may have its own haircut ratio, you must link the bond with its own repo trade. And there are also cashflow issues, such as coupon payment.

    Issues 2. Trades are simultaneously done. Trader will set them at the same settlement date. Theoretically you won't need to pay extra funding cost if every thing goes smoothly. If not, you could probably claim interest from your faulty counterparty.

  3. If the market has central clearing service or you can even buy the bond and do repo trade with the same counterparty, the receivables and payables will be matched and sometimes net settled. Thus no need to worry about the timing difference.

  • $\begingroup$ Please can you formulate this as an answer, rather than a response to my comment, and I'll accept as the answer. $\endgroup$
    – quanty
    Commented Mar 1, 2021 at 10:23
  • $\begingroup$ As you wish, has restructured it. $\endgroup$
    – xing gao
    Commented Mar 1, 2021 at 11:29

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