CFM17170 - Repos: commercial background: general collateral repos

A description of general collateral repos

The original owner under a repo is a person who currently owns securities - shares or debt instruments - and sells them for cash. The repurchase price is computed by applying an interest rate to the cash received for the securities in the first leg of the transaction. This rate is known as the repo rate. The rate should theoretically be based on the secured lending rate for a loan equal in term to the length of the repo. However, the correlation will be affected by factors such as the demand for borrowing of this sort and the quality of the securities sold (collateral).

The repo rate is not dependent on any movement in the market price of the securities during the term of the repo. So the interim holder is not directly exposed to market risk in relation to the underlying securities-although it could become exposed if it sells them since it will then have repurchase them at a later date to meet the return leg of the repo.

Since the interim holder actually owns the securities, it is not exposed to credit risk and in the event of default can simply sell the securities. As a result the original owner’s own credit rating is not an issue so it will normally benefit from a low interest rate. Like stock loans, a haircut CFM17070 is usually required on a repo. In most cases the sale price for the securities in the first leg of the transaction will be a few percent below the market price of those securities. This means that the lender of cash has securities as collateral which are worth more than the amount of the loan, providing an extra degree of protection against default.

A simple example of a general collateral repo is at CFM17170a. A more complicated example is at CFM17170b.

Additionally the collateral position is margined daily. The value of the securities is ascertained and the amount compared with the cash advanced plus accrued repo rate “interest” on the cash. Extra securities may have to transferred, or returned, depending on the result of the comparison.