1: Financing Products – Common references

Pricing of a Repo Agreement

Mini Chapter One

Financing Products - Common references

We are about to navigate back and forth between cash and derivatives and their mix to discuss some popularly talked about financing solutions in the fixed income world. Let’s start with the basics:

1. Cost of Funding

The value of any financial asset or liability depends on its expected future cash flows, present value of which is obtained by discounting it at a rate commensurate with the risk of the asset or liability. This discount rate is interchangeable with the internal rate of return or the expected return on that funding over a specified tenor.

If you had to link the risk profile of an asset or a business with its expected return – higher risk warrants a higher return over the risk free rate – this return would determine the marginal cost of funding today or to be more nuanced the present enterprise value for a business.

Higher the risk of the funding instrument greater is the return expectation and so the funding mix for any business would depend on its risk profile. For instance, Banks would have a lot more debt as a proportion of its total financing given their ability to lever up on the equity capital (equity is the riskiest/most expensive funding instrument) versus private non-financial corporates, that means a lower average cost of funding for banks vs the non-bank sector.

2. Secured and Unsecured Funding

Simply put unsecured funding is funding to an entity without prejudice to any of their owned assets while secured funding is what is backed by a defined charge on the assets (exclusive or not). In addition, secured funding may or may not have recourse to the entity/borrower of funds – common example being a collateralised loans portfolio of a bank that has recourse to the loans but not to the bank.

For the sake of restricting the content to collateralised credit instruments (for now) let’s focus on secured funding products:

Repurchase agreements (Repo) – Is a mode of financing against underlying assets with a promise to return the underlying at the end of the borrowing term at a fixed price. Most common example is a repo against a sovereign bond that’s generally priced as a non-recourse borrowing since risk of the underlying will most times be superior to the credit risk of the borrower. Cost of this financing or the repo rate is a function of the risk of the underlying (being repo-ed) and its relative demand/supply.

Connecting the dots. FX swaps are also a form of repo financing i.e. collateralised exchange of cash in different currencies, implied yield on which is determined by the relative interest rates.

• Repos can be understood as short term financing collateralised by assets (legal title transfer) hence its pricing tracks money market yields. Percentage notional of cash lent against an asset (also called Loan to Value, LTV) is a function of the asset’s risk profile/volatility and the tenor of funding. Terms like margin and haircut are also used to reflect the LTV amount, but to importantly assess the overcollateralization of the loan it’s key to understand the difference between the terms. For instance, an 80% LTV which means $80 lent against equity value of $100 – denotes a haircut of 20% (on the value of the equity being repo-ed) but a margin or over-collateralisation of 25% (i.e. 20%/80%) on the cash lent.
• Pricing generally assumes no recourse to the borrower i.e. margin is largely a function of the underlying security/bond being repo-ed.
• Actual funding rate is implied by the difference between the purchase price of the asset (lender of funds) and its sale price on maturity when the repo transaction reverses. Effectively it’s the holding period return for the lender of cash/holder of the collateral security.
• Arbitrage can be created if the repo funding rate differs from the underlying asset’s yield curve for eg. if a 3m repo rate on a 3m Treasury bill is at a rate lower than the 3 month bill’s yield it would create an arbitrage for an investor to borrow funds at repo and invest it in the bill. For the lender of the funds the recourse (full ownership) is only to the T-bill, hence even in case of a default the investor who has funded the bill with repo doesn’t run any risk i.e. his pay-off is either positive or nothing. Conversely if the repo yield is higher than the treasury bill yield it wouldn’t make sense for the investor to finance it on repo as they could generate the funding cheaper by selling the asset itself.

Risk on a repo transaction

Two types of risks to think about:

• Market risk– It’s worth noting that Market traded repo rates are general fixed rates (even though one can structure bespoke repos on floating rate) i.e. fixed at the time of entering the contract. Thus, movement in money market yields or the repo rates i.e. change to the refinancing cost during the repo contract has interest rate (mark to market) risk like any fixed rate instrument.
• Credit Risk – Is the risk (as priced in the margin) of default of the underlying asset assuming no recourse to the borrower as mentioned above. To mitigate credit risk, terms of the contract can be reset if credit risk worsens and the price of the underlying drops below key triggers.