A Repo Example

A brief description of Repo

The repo (sale and repurchase agreements) business is not well known to the public. Repo involve the sale of securities (as collateral) and the simultaneous undertaking to repurchase those securities at a later date. The maturity date is either fixed at the outset of the agreement, or extended on a day-to-day basis (open repo). Essentially, a repo simply represents a loan that is backed by investment securities.

Upon expiry of the repo contract, the seller is obliged to repurchase the collateral at the original selling price. In addition, he pays the buyer interest based on the duration of the loan and the principal amount involved.

If the seller were to default on his obligation to repay the money, the purchaser is entitled to sell the pledged securities. Conversely, the seller can use the loaned amount to replace his securities if the buyer fails to return the original collateral.

Both the risk and reward associated with the pledged securities accrue to the seller. He remains the beneficial owner, even though the buyer owns the collateral during the term of the agreement. Should the value of the securities fall during the contract period, the seller incurs the loss. He also bears the risk of default by the company which issued the securities. The buyer's risk is thus negligible, as the seller and the issuer are most unlikely to default simultaneously.

Phase 1

A bond trader (the seller) wishes to borrow € 25 million to finance the purchase of € 24 million of 6.5% Bund 2003 securities for one week.

Phase 2

A repo dealer (the purchaser) offers the bond trader a repo rate of 5.25%.

Phase 3

The bond trader accepts the offer. On the value date, he delivers the € 24 million principal amount of 6.5% Bunds of 2003 against € 25 million in cash.

Phase 4

On the value date, the repo dealer pays € 25 million in return for the € 24 million nominal amount of 6.5% Bunds of 2003.

Phase 5

At the end of the one-week term of the contract, the purchaser returns the € 24 million of Bunds to the seller. The latter repays the loan of € 25 million, plus interest of: