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.