HOFIS Ch. 60: Financing Positions in the Bond Market

Question 1

Describe the features of a repurchase agreement

Answer 1

A contract where you sell a security to a party, and agree to buy it back at a future date
(the repurchase date)

The price at which the security is bought back is the repurchase price, and is
typically greater than the selling price

The interest rate behind this loan is the repo rate

The trader entering into a repo transaction with a repo dealer is borrowing cash
(the sale price) in exchange for using the security as collateral

Question 2

Define the term haircut, in the context of a repurchase agreement

Answer 2

To reduce credit risk exposure, the cash amount that is lent is typically less than the
market value of the security used as collateral

This provides the lender with a cushion in case the market value of the security
declines

The amount by which the market value of the security exceeds the value of the
loan is the margin, or haircut

Question 3

List some factors that influence the value of the repo rate

Answer 3

Quality of the collateral

Term of the repo

Delivery method of the collateral

Availability of the collateral

Prevailing federal funds rate

Question 4

Describe two advantages from using repurchase agreements

Answer 4

From the borrower’s side, the repo rate is typically pretty low and less than other
costs of financing (i.e. LIBOR)

From the perspective of the entity lending cash, the repo market offers an
attractive yield on a short-term transaction that is secured and is highly liquid

Question 5

Describe two ways in which a dollar roll is different from a repurchase agreement

Answer 5

The party who borrows the securities does not need to return identical securities
at the repurchase date
Ÿ In exchange for this flexibility, the financing cost offered by the security borrower (the
party who is lending cash) may be cheaper than a repo

The security borrower will keep the coupon and principal payments made by the
security

Question 6

Describe a few elements to consider when determining the financing cost of a dollar roll

Answer 6

The difference between the initial sale price and repurchase price (called the
drop)
Ÿ The repurchase price may be less than the purchase price

Amount of scheduled principal payments and projected prepayments of the
security sold
Ÿ A gain will be realized by the security borrower on any principal repayments if the
security is purchased at a discount
Ÿ Similarly, a loss will be realized if the security was purchased at a premium

The attributes of the substantially identical security that is returned by the
borrower

Question 7

Describe the features of a security lending transaction

Answer 7

In a security lending transaction, one party (the security lender) lends a security to
the second party (the security borrower )

The security borrower agrees to return the identical security to the security lender
at some time in the future

The security lender will also pay the security borrower a rebate at the end of the
contract

The borrower needs to pay the lender any interest or dividend payments made by
the security

Economically, a securities lending contract is very similar to a repurchase
agreement