How Repos Work - Some Uncomplicated Excel Sheet Indulgence

So I’ve been focusing on the money markets recently as my upcoming posts will certify - the reason for this focus being sublimely profound. Ha (kidding) – not a chance! It does owe its genesis to the frustrations of youth though.  As a student in college I found study materials on money markets (financial markets in general actually) exasperating – replete with commentary and jargon, but light on real-market illustrations. Is it really too much to ask for a simple, real-world example involving some basic math? Not on Nerd Verve it isn’t!

So here’s some uncomplicated excel sheet indulgence  (would be mandatory for students in a perfect world) that illustrates clearly (I hope) how repos work.

Before the math....what is a Repo?

A “Repo” or Repurchase transaction is one where one party (seller) sells securities to another party (buyer) at a particular price, with the promise to buy-back back said securities at a future date at a different pre-agreed price.  This repurchase price includes the interest payable to the buyer for agreeing to buy the securities, which is called the “Repo rate”.

What is essentially happening here is that the seller  (of securities) needs short-term funds, and the buyer (of securities) has idle short-term funds that he’d like to earn interest on. Through a repo transaction, the seller is able to borrow funds at a cheaper rate against a collateral of securities, while the seller is able to deploy his near-term funds while minimising credit risk by accepting collateral. If the seller (borrower) defaults, the buyer (lender) can sell off the securities to prevent loss.

So even though Repos are structured as a sale and repurchase of securities, in effect they are short-term loans against collateral. 

In India, the securities involved in repo transactions are government securities. The repo market is mostly over-night, though the RBI has also introduced (since Oct 2013) 7-day and 14-day repos to encourage the development of a short-term yield curve. (we’ll talk more about this in later posts)

And now....Drum roll please....comes the nerdy fun part!

Below is a simple example of how an overnight repo actually works for the parties involved.

Simple Repo worksheet

We’ve taken the example of an overnight repo transaction where Party A sells a 9%, 2020 government security (with annual coupon payments on the 18^th of Dec every year till maturity) to party B. For those not familiar with Government security or G-sec jargon, a “9%, 2020 G-sec” means a government security with annual coupon payments of 9%, which matures in 2020. Remember: the coupon is always calculated on the face value of the security (Rs. 100 in this case) and not on its current market price. The current market price of the g-sec in question is Rs. 103.00. Note: this is the “clean price” of the security which means it does not include the interest accrued on the security till date.

Lets assume the 1-day repo transaction is undertaken today (18-8-15). How much does party A sell the g-sec to party B for? Or alternatively, how much does party A borrow from party B? This amount is = the g-sec’s “clean price” + accrued interest. We know that the clean price = Rs 103.00. The calculation for accrued interest is simple. The last coupon was paid out on 18^th Dec 2014. So, accrued interest for the g-sec today (18-8-15), 8 months or 240 days later = 240/360 * 9% *100 = Rs 6.00.  We usually use a 360-day year for calculating accrued interest. So, the cash received by party A for the sales of the g-sec = Rs 103.00 + 6.00 = Rs 109. 00.

Tomorrow (19-8-15), party A will buy back the g-sec from party B for a price that is = Rs 109.00 (cash received from B) + repo interest on cash received. Since the repo rate is assumed to be 8.00%, the repo interest is = 109.00 * 8% * 1/360 = Rs 0.02. “A” buys back the g-sec from “B” for Rs 109.00 + 0.02 = Rs 109.02.

The numbers in this example are tiny since we’ve used just a single g-sec to illustrate an overnight Repo transaction. Suppose the transaction involved 2 crore bonds. In this case, the cash received by A (part 1 of repo transaction) would be = Rs 109 * 2,00,00,000 = Rs 218 crore. The repo interest on the transaction would be = Rs 4,84,444 (@8% for 1 day). Finally, the repurchase price paid by A on 19/8/15 would be = Rs 218,04,84,444.

What’s next? Haircuts - but not the kind your stylist gives you.

Now that we know how a simple overnight repo transaction works, we’re ready to talk about “haircuts” – a device used by lenders (security buyers) in the repo market to further protect themselves against credit and liquidity risks.

Watch this space.....