Repos

It has been a while since I wrote the last piece. Basically I am in a fix. I am now in the second year of my MBA and am supposed to be studying advanced topics. That means that I am stuck with a number of assignments each day which I do not understand how to do. As for the basic finance courses that I did in the first year, I have forgotten most. So I hardly find anything to write about. The last two pieces consisted of stuff one would come across while studying the first couple of chapters of Brealy Meyers.

Anyway, I am currently doing a course called Fixed Income Securities. As the name implies, it is about bonds. We had a test a couple of days back which forced me to study the book. In the process I came across something interesting called Repos or Repurchase Agreements. I am going to write about it now before I forget it!

The size of the transactions in the bond market is usually very high. Most transactions reach crores of rupees. So at first sight, it appears that to be a speculator in the bond market, one has to have a large amount of capital. In reality, this is not the case. The concept of repos makes this possible. It enables speculators with a capital of a few lakhs take up highly leveraged positions in the bond market worth a few crores.

A repo is basically a repurchase agreement. Conceptually, it is an agreement wherein I sell my bonds to a repo dealer with the agreement that I will buy it back from him after a specific amount of time. Often, this specific amount of time can be just a day. This is the point of time when smart students of finance work out that a repo is no more than a collateralised loan. I did not and so to help fellow beings with equally high density, I will go a bit deeper into the subject. Let us consider the following typical transaction.

On August 1, 2005, let us assume that Bond X had a market price of Rs. 94.50. This is the flat price or clean price of the bond. This is typically not the invoice price. The invoice price or the dirty price includes the accrued interest which is the coupon income that accrues from the last coupon date to the settlement date of the transaction. Let the accrued interest of this bond be Rs. 0.40. Therefore, the dirty price of the bond at which it is available in the market is Rs. 94.90. I want to buy 100,000 such bonds. The market price of this today will be obviously Rs. 9,490,000. I do not have this kind of money. So I approach a repo dealer. I tell him that if he will lend me the money required to buy the bonds, I will transfer them to him immediately and buy them back from him three days later through a repo agreement. It being his profession, the repo dealer agrees. But no repo dealer pays the complete market price of the bonds to be purchased. He takes a haircut, a kind of an advance that will force me to invest some money of my own. He takes a haircut or 0.5%, that is, 0.5/100*9490000=Rs. 47,450. Therefore, he lends me Rs. 9490000-47450=Rs. 9,442,550. I add Rs. 47,450 from my pocket and viola! I have the bonds.

As per the agreement mentioned above, I immediately hand over the bonds to the repo dealer. Let us analyse the situation now. The repo dealer has lent to me Rs. 9,442, 550 and in return, I have given him bonds worth Rs. 9,490,000 today. The bonds are basically the collateral in return for which the repo dealer has lent me the money. This is the collateralised loan I was talking about. If I default in the repayment of my loan three days later, the repo dealer simply needs to sell the bonds in the market to regain his principal (assuming the price does not fall significantly).

Now, let us fast forward three days ahead, to August 4, 2005. On this day, I am supposed to repay the debt. I see the market price of Bond X is Rs. 96.90 and the accrued interest is Rs. 0.45. Therefore, the dirty price is Rs. 97.35. Therefore, the bonds that I had bought and given as collateral to the repo dealer are worth Rs. 9,735,000 today, the 4^th of August, 2005. So I take the bonds from the repo dealer and sell them off in the market and get Rs. 9,735,000. Now I have to return the money loaned by the repo dealer.

The repo dealer charges an interest of 6%. Therefore, the amount I owe to him today is 9442550*(1+0.06*3/365)=Rs. 9,489,116. I pay him this amount and what I have left is 9735000-9489116=Rs. 245,884. This is the amount I have earned today.

Now let us calculate my profit. I had invested Rs. 47, 450 from my pocket. Assuming my own cost of capital is also 6%, the value of that amount today is (1+0.6*3/365)*47450= Rs. 47, 684. Therefore, my profit today is 245884-47684=Rs. 198,200. That is a very neat amount to earn in 3 days!

Well, this transaction turned out to be quite neat because I had correctly speculated the rise in the price of Bond X over the next 3 days. Had it been the opposite, I may have as well lost the neat amount.

Well, so ends my discourse on repos. Of course, the test was far more complicated and involved possible ways of running scams using the repo. But I have written enough for a day. If anyone is really interested to know what the scams in the test were, please let me know. And just for information, the RBI is the repo dealer in India.

First lesson on money machines

There are two very elegant and obvious axioms in finance. The first one is that a rupee today is worth more than a rupee tomorrow. Simply put, if I give to you the rupee I have today, you should return to me more than a rupee tomorrow. The second one is that a secure rupee is worth more than a risky rupee.

Let us make this matter frivolous by bringing in my obsession with food. There is this friendly neighbourhood restaurant where the special dish today is Chicken Biriyani, cooked in my favourite Avadhi style rather than the not so good Hyderabadi style. A plate of it costs Rs. 100 (no, in reality Chicken Biriyanis are cheaper but 100 seems such a nice round number!) My plan was to devour a plate of it for lunch.

This is when you come along and ask to borrow that Rs. 100. You promise that you will return the money tomorrow. This of course means that I cannot eat the Biriyani today but will have to eat it tomorrow. Skipping the meal for you today will mean that I will be hungrier tomorrow than I am today. To satisfy this enhanced hunger, I will need to order a mutton champ worth Rs. 50 along with the Biriyani worth Rs. 100. Therefore, I will lend Rs. 100 to you today only if you return Rs. 150 to me tomorrow. This result stems from the time value of money, which is the first axiom mentioned above.

But that is not all. There is a distinct possibility that the special dish will not be Chicken Biriyani tomorrow. To eat the chicken biriyani, I will have to go to another restaurant slightly farther off and that will cost me a taxi fare of another Rs. 50. Therefore, I will risk lending you the Rs. 100 today only if you return to me Rs. 200 tomorrow to cover both the mutton champ and the taxi fare. This result stems from the second axiom, which basically talks bout risk.

I do not like risk. You may think that is because I hail from a middle class Indian family and for middle class Indian families, financial security is the one and only goal. That may be true to some extent but the major reason is that studying risk involves a lot of math and I hate it. Luckily, most beginners of financial theory seems to share this attitude of mine and most basic theories of finance are based only on the time value of money with risk factored in much later.

Today I want to write about a money machine. To introduce it, I will go back to the frivolous example I quoted above. Suppose that you say that you will not return the money to me tomorrow but day after tomorrow. Of course, by day after tomorrow, I will be hungry enough to eat a Kulfi as dessert after the biriyani and the champ. The Kulfi costs Rs. 25. Keeping the risk factor out for the time being, I will lend you the Rs. 100 today only if you return to me Rs. 175 day after tomorrow.

This brings us to what appears to be an obvious conclusion. The longer I lend the money for, the higher I will expect the return to be. Conversely, the longer I borrow the money for, the greater the interest I will have to pay. This is why banks give higher interest rates on three year fixed deposits compared to one year fixed deposits. This is why the Estimated Monthly Instalments (EMI) we pay against loans add up to a higher value when paid over a longer period of time.

It is at this juncture that you will start thinking that a theory built on something as dubious as chicken biriyani cannot be serious. What if you start a bank and do the opposite? What if you charge lesser interest for longer lending and your friend charges you lesser interest for longer loans? Will you become the next financial magician and investors from the world over flock to you and your friend? Yes, they will flock to you all right but you will be bankrupt sooner than you can say bankrupt, along with that good friend of yours. This is because you would have created a money machine. Let me explain how.

Let us assume that you charge an interest of 20% when you lend money for one year and 7% when you lend money for two years. Your friend borrows money for one year and pays an interest of 20% but pays only 7% interest when he borrows for two years. You and your friend work as a team. Therefore, your firm lends and borrows at 20% for one year and 7% for two years.

I go to your firm, which is called Morons Ltd., and deposit Rs. 1000 for one year. Since we are keeping risk out of the picture, I am sure that I will get Rs. 1200 at the end of the first year. Even if I just keep the money with me for another year, I will have Rs. 1200 at the end of two years. I go to your firm again and show to you that I will have a guaranteed Rs. 1200 with me at the end of two years. As per your rules, you will then lend me 120/ (1.07^2) = Rs. 1048.1. Thus, I have gained Rs. 48.1 without doing anything.

You may always smirk and say that a paltry gain of Rs. 48.1 will hardly make me a millionaire. But remember that I need to do it only 147 times to become a millionaire!

I think two clarifications are necessary here. The first one is that money machines do not exist. This is because money attracts more brains than anything else (definitely science!) and so the moment any such arbitrage opportunity opens up, people flock to it either to neutralize it or to render the fools responsible for it bankrupt. The second clarification is that risk free investments do exist. Government bonds are supposed to be risk free.

First class on Corporate Finance

Anyone who has ever toyed with the idea of becoming a writer knows that writing involves great discipline. It is not as much fun as reading and the adage well begun is half done does not apply to writing. Also, it is said that writing about a topic is the best way to learn the topic. This effort of mine is therefore expected to achieve dual benefits. First, it should be able to lend some discipline to my otherwise aimless life and it should also be able to help me learn the intricacies of the world of finance.

Let me caution the reader now itself that I am a beginner as far as finance is concerned (coming to think of it, I am practically a greenhorn.) Reading on will add value to you only if you have absolutely no idea about finance but want to accompany another beginner in his journey of discovery!

Let me begin by narrating the financial habits of my father in contrast to my own financial habits. My father likes to save. That’s putting it mildly. Supreme happiness for him means depositing his entire salary in some secure instrument such as the Provident Fund for the employees of the Government of India. I am quite the opposite. Money bites me and I am always keen to get rid of it. I know a few restaurant owners who thank their stars everyday for this habit of mine.

Therefore, it follows that if given Rs. 100, my father would promptly deposit it in some saving scheme and I would spend it, slightly more promptly.

One fine day, along comes this fine young Financial Manager. For convenience, we will ascribe to him the highly imaginative acronym FM. He says that if anyone gives him Rs. 100, he will invest it in a project that will guarantee Rs. 125 at the end of the first year. The financial manager is the modern incarnation of Yudhishthir and therefore he cannot lie and we can rest assured that Rs. 100 invested in this project will become Rs. 125 in one year (problems start when we take this guarantee away. But like a physicist who is allowed to consider a horse to be a sphere for simplicity, I am also allowed to assume the existence of perfectly honest financial managers.) The FM also mentions in the passing that the current borrowing rate in the neighbourhood bank is 10%.

My father, as expected, promptly pays up and moves one step closer to supreme happiness. On the other hand, I am confused. The urge to retain the money and spend it on a nice juicy steak is almost irresistible. I know I will gain Rs. 25 if I deposit the money but postponing a steak for one whole year is not my way of doing things. So I decide to be noble and resist the urge of the extra Rs. 25 and spend the money right then. By doing so, I prove that I am a complete financial idiot.

Instead, had I been a financial wizard, I would have promptly paid up and taken a written promise from the FM that he will return Rs. 125 to me in one year. I would have then walked into a local bank and given them the written promise, thereby convincing them that one year from now, I will surely be able to pay them Rs. 125. Since the borrowing rate is 10%, the bank would have gladly lent me (125/1.10)*1 = Rs. 113.64 right at that moment. So, not only would I have had money to spend, I would have actually had Rs. 13.64 extra to spend right now.

And this brings us to a very elegant conclusion regarding the world of finance. As the FM here had so deftly done, the guiding aim of the financial manager is to find projects that will increase the value of the shareholder’s wealth. To put it less politically correctly, it is his job to find or design investments that will have returns higher than the returns the investors normally expect. If he can do so, every investor, regardless of his spending (or saving habits) will have reasons to invest in the firm. A true financial wizard is one to whom every person in this world wants to give her money to!

Therefore, the trick is to be able to correctly identify investments that have such characteristics. Learning corporate finance is about mastering this trick.

And so I start

And finally I have gotten myself to create a blog for myself. Of course, I have no clue when I will put the first posting. But well, at least now I have a forum.

I will primarily use this blog to say things I don't find audiences for. But occassionally, I plan to write about my experiences with trying to study finance. I will mention at the top of the article whether the article is related to finance or not.

Gotta run. Have a class.