Fixed Income Securities

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Fixed Income Securities and their Derivatives
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Repo
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Whats Repo?

• A repurchase agreement, or repo, is a single
  transaction consisting of
• A spot portion in which a security is sold for
  cash and
• A forward portion in which the security is
  repurchased for later settlement
• Dealers often use repo to finance inventories of
  securities
• Repo can be for overnight, term or open

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Repo Spot Portion
Collateral
Securities Dealer

• Investor

Day 1
Cash (Principal)
At settlement, the collateral is sold for cash
(good funds) to an investor.
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Repo Forward Portion
Collateral
Securities Dealer

• Investor

Day 2
Cash (Principal Interest)
At maturity, the dealer repurchases the
collateral for cash. The extra cash paid at
maturity is interest and is determined by the
repo rate.
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Repo
Collateral
Securities Dealer

• Investor

Day 1
Cash (Principal)
Collateral
Securities Dealer
Investor
Day 2
Cash (Principal Interest)
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Example
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Terminology

• The party who sells collateral in the first leg
  and repurchases collateral in the second leg is
  called the repo seller.
• Dealers who finance securities with repo are repo
  sellers.
• The other party is the repo buyer.
• Investors who invest in repo are repo buyers.

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Repo Mechanics

• Margin
• Margin is collateral in excess of the principal
  amount of the transaction
• Demanded to limit credit exposure
• Typically 1 to 3 (5 to 10 for riskier
  collateral)
• Example If margin is 2, a dealer would deliver
  10.2 million (market value) of collateral
  against a principal amount of 10 million.

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Example T-bill Margin
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Repo Mechanics

• Marking to Market
• Collateral may be marked to market and the trade
  adjusted
• Margin call If collateral value declines,
  additional collateral may be required to restore
  the original margin. (Dealer delivers more
  collateral to investor.)
• Repricing If collateral value declines, the
  principal amount of the transaction can be
  reduced to restore the original margin. (Dealer
  wires cash back to investor.)

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Repo Mechanics

• Collateral
• Substitution
• Dealer may request the investor to return the
  original collateral in exchange for different
  collateral having the same market value
• If collateral cannot be substituted, it is
  special
• Cash flows
• The repo seller is entitled to receive any
  interest or principal payments off the collateral

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Repo Mechanics

• Collateral
• Delivery
• Outright Seller delivers the collateral to the
  buyer. Buyer returns the collateral at maturity.
• Safekeeping Seller holds the collateral for the
  buyer. Also known as letter repo or held in
  custody repo.
• Third party Seller delivers collateral to
  purchasers custodial account at sellers
  clearing bank.

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Reverse Repo

• A reverse is a repo viewed from the perspective
  of the counterparty lending cash
• There are two reasons for doing reverses
• Investors seeking short-term relatively safe
  investments may invest in repo.
• Traders seeking to cover a short position in a
  security may borrow the needed securities by
  doing a reverse for specific collateral

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Repo Rates

• General collateral rates
• Relation to the Fed funds rate
• Specials
• Rates can go special when there is strong demand
  for specific collateral
• Example Traders as a group build up a sizeable
  short position in a particular issue.

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Repo Books

• Dealers often work both sides of the market,
  doing repo with one group of investors and
  reverses with another.
• In a matched book, a dealer reverses in
  securities from one party, repos them out to
  another party, and profits from the spread.

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For Example

• A Brazilian bank finances some of its Brazilian
  Brady holdings by doing a repo with a dealer in
  New York for LIBOR 1
• The repo dealer in New York uses the collateral
  to do a repo with an American investor for LIBOR
• The dealer pockets the spread (1)

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Application Tailing

• If you buy a 90-day T-bill and hold it for 30
  days, it becomes a 60-day bill.

30 days
60 days
Finance for 30 days
Buy 90-day bill
Own 60-day bill
Bill matures
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Application Tailing

• To create a T-bill tail
• Buy a T-bill with t1 days to maturity
• Finance it for t2 days with term repo
• Inherit a T-bill with t1 - t2 days to maturity
  when the financing comes off.
• Dealers use this strategy to buy T-bills forward
• Why buy bills forward?

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For Example
A dealer creates an 83-day bill tail
In effect, the dealer purchases the 83-day bill
for a rate of 4.41
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Quick Check

• Explain the mechanics of a repo transaction.
• What is margin in the repo market? Why is it
  needed? How does it vary by collateral?
• How do repo rates go special?
• Whats a bill tail? How do dealers create them?
  Why?

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Review

• Scope of the money market
• Three bases for measuring yield
• Effective yield and Bond Equivalent Yield
• Details of the T-bill market
• Mechanics of the RP market

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Now
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Bonds, Bonds, Bonds
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What is a Bond?

• A bond is a debt contract between
• The issuer (borrower), and
• The purchaser (lender).
• Bond indentures
• Detailed description
• Cash flows
• Security interests
• Covenants
• Default provisions
• Role of trustee

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Sellers and Buyers

• Bonds are issued by
• Sovereigns and other government agencies
• Corporations
• Bonds are purchased by
• Institutions
• Financial corporations
• Individual investors

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Bond Characteristics

• Principal and coupon
• Corpus
• Coupons (frequency)
• Zeros
• Maturity
• Prepayment option
• Hybrids
• Convertibles

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Bond Markets

• Primary
• Auction mechanisms
• Placed issues
• Private placements
• Public offerings
• Secondary
• Exchange traded
• OTC markets

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Example

• The US government 8 3/4 of 5/15/20
• Originally issued 5/15/90 as a 30-year bond
• Not callable
• Par bond (issued at par redeemed at par)
• Pays 4.375 semi annually
• Traded OTC
• Recently quoted at 13121 ask (5.98 ytm)

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Example

• Kyushu Electric Power
• 40 billion yen issue of 10-yr bonds
• In Japan
• Denominations 1MM yen thru 100 MM yen
• Issue date 11/10/00 Maturity date 11/25/10
• 2.00 coupon payable semi annually
• Priced at 99.99 (2.001 ytm)
• Lead manager was Mizuho Securities

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Example

• Mexican (Brady) Series A Par Bond
• Issued March 1990
• Original issue maturity of 29 3/4 yrs
• 6 1/4 fixed coupon
• Principal (face amount) backed by US Government
  zeros
• Designed to replace defaulted loans
• Sold at well below face value initially
• Risky coupon

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Bond Pricing

• The bond equation
• Equates a bonds price to the discounted present
  value of the future cash flows associated with
  the bond

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Next
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Bond Pricing