A few weeks ago, we introduced the topic of repurchase agreements (repos). Today, we will present a worked-out example of a repo transaction so as to better illustrate its most important concepts. In this example, Prime Broker B finances repo positions for Hedge Fund H. Two broker/dealers, Broker M and Broker S, also participate as counterparties in this example.
Repos provide leverage: Hedge Fund H gets the use of a security without having to expend the purchase price of the security. Instead, Hedge Fund H is charged repo interest on the cash borrowed from Prime Broker B, which is offset by the coupon interest Hedge Fund H earns on the security; the difference is the carry on the trade (cost of keeping the position on). Thus, Hedge Fund H is able to finance many more securities this way as compared to outright purchase.
On Monday, Hedge Fund H purchases $1M face of 10-year Treasury note with a 6% coupon at a price of 101 from Broker M in the cash market. There is $20,000 accrued interest in the note as of Tuesday, for which Hedge Fund H must pay. The settle date for the purchase is Tuesday (i.e. it is regular settle; cash settle would occur on Monday). On Tuesday, Broker M delivers the Treasury Notes to Hedge Fund H’s custodian, Prime Broker B, and Hedge Fund H wires $1,030,000 ($1M face * 1.01 + 20,000) to Broker M.
On Tuesday, Hedge Fund H also enters into a 1-week term repo transaction with Broker S for $1M of the same Treasury Note, which is now priced (on Tuesday) at 101.5. The repo interest rate on collateral is 5%. The full price of the note (that is, including accrued interest) is 103.5. Broker S charges a 2% haircut on the Treasury note. Hedge Fund H delivers the $1M par of Treasury notes to Broker S on Tuesday. Broker S pays Hedge Fund H ($1,035,000 full price / 1.02% haircut) = $1,014,706 proceeds. (In reality, the price is usually rounded. In this case, it would probably be rounded to $1,015,000).
Note that Hedge Fund H paid out $1,030,000 for the purchase of the security, and received in $1,014,706 by repo’ing the security. Thus, Hedge Fund H’s net cash flow is -$15,294 on the first Tuesday. This reflects both the haircut and the price movement of the security.
For the one week period (Tuesday to Tuesday), Hedge Fund H accrued 7 days of coupon interest at 6% annual on $1M = (7/182) * ($1M) * (.03) = $1,153. The note is currently carrying $20,000 + $1,153 = $21,153 accrued interest.
The current price of the Treasury note has risen to 103 over the last week. Hedge Fund H sells the Treasury note to a counterparty for $1,030,000 + $21,153 = $1,051,154.
On the same day, Hedge Fund H receives its $1M par Treasury Notes back from Broker S. No coupon was paid during the period. Hedge Fund H calculates the repo fee to Broker S as 5% on the $1,014,706 proceeds for 7 days = (7/360) * ($1,014,706) * (.05) = $986. This repo fee plus the original proceeds of $1,014,706 sums to $1,015,692, which is the amount Hedge Fund H wires to Broker S.
Note that Hedge Fund H paid out $1,015,692 when terminating the repo, and received $1,051,154 for selling the note, giving Hedge Fund H a positive cash flow of $35,462 on the second Tuesday. When this cash flow is netted against the cash flow from the previous Tuesday of -$15,294, the total profit from the transaction is calculated to be $20,167.
The gain or loss on the buy and sell of securities, calculated on a FIFO-lot basis, plus the interest income earned, less the interest expense incurred, represents the total profit from security trading. Repos and reverse repos are simply methods to finance security trades.