Ok for some reason I am having a problem understanding what probably is a very simple concept of a repurchase agreement. When the borrower agrees to repurchase the security from the buyer, is the buyer basically short selling this? If he owned a $5 million dollar treasury bond, why would he sell it and pay a interest cost and try to earn a small spread versus just continue to hold it. Please someone help
Repos agreement is something banks do to have to short term liquidity. When you heard that the FED lower interest rate. this is the rate it is talking about because bank use that rate to lend to each other. But to do so the post liquid security as collateral. Realize if the sell the security, they might end up loose more should those security appreciate later on. the rate on the loan is way cheaper than the yield on these securities. Therefore, you want to continue to do so.
We do same thing with futures also. We can avoid paying taxes by selling and reacquiring. Repo collateral may be denominated in another currency, repo collateral may not be a T-Bond, it can be a corporate bond etc. We are borrowing using our collateral, which we dont wish to sell but keep. Hope this helps.
repos are commonly used for leverage…
to go further, as i should explain more. i repo a 10mm corp bond position. there will be a collateral haircut (which isn’t really discussed by schweser), but say the bank then gives me 9mm to use elsewhere. i pay repo rate interest on the full 10mm…but cost of financing will be much lower than income i get on the corporate bond and from using the 9mm elsewhere. its a collateralized loan at its simplest and therefore is the way to finance positions. i give a piece of jewelry to a loan shark and he gives me funds that i owe back + interest. same deal make sense?
Thanks a lot everyone…totally helped me out. On to the next subject
Apparently there’s lots of people here dealing with Repo’s in practice… I always wondered if - in that order - the Repo rate is higher than the money market rate among banks (e.g. LIBOR) which in turn is higher than government T-Bill yields because of credit risk? Is credit risk the differentiator among all those different “money market” yields? Does someone know?
credit risk (especially these days) is a huge driver of repo rate. if im a small regional bank and i borrow money from a big money center bank im going to pay a rate higher than LIBOR or t-bills b/c of credit risk. even with the collateral, collateral can easily go down in value (again, especially these day)