Repurchase Agreements “Capital Markets” -- Ch. 20 M Kim

Repurchase Agreements The sale of a security with a commitment by the seller to buy the security back from the purchaser at a specified price at a designated future date. collateralized loan overnight repo: 1 day term repo: more than 1 day

An example of repo transactions dealer customer borrow money lend money give collateral accept collateral “reversing out” “reversing in” $10 million of the bond

Repo rate Dollar interest = Dollar principle * Repo rate * Repo term/360 The interest is computed on a 360-day basis. Ex: overnight rapo rate = 6.5% $ 9,998195 * 0.065 * 1/360 = $1805

Credit risks Practices to limit credit risk The amount of loaned is less than the market value of the security used as collateral. Mark the collateral to market on a regular basis.

Participants in the market dealer firms Ex: Borrow at 7.5% and lends at 7.55%, locking in a spread of 0.05% repo broker Federal Reserve

Determination of the repo rate Quality Quality , liquidity  repo rate Term of the repo Depends on the shape of the yield curve. Delivery requirement Delivery of the collateral to the lender is required  repo rate Availability of collateral More difficult to obtain the collateral  repo rate

Federal funds rate & repo rates Federal funds rate determine the general level of repo rates. The repo rate will be below the federal funds rate. Typically the spread is about 25 basis points.

Federal funds Required reserves of depository institutions No interest rate is earned on federal funds, because of an opportunity cost. Commercial banks are the largest investors in federal funds.

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