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.
