Repurchase Agreement

The economics are those of a secured loan. The cash lender advances less than the market value of the securities received; the shortfall is the haircut, and the ratio of collateral value to cash advanced is the initial margin. A 2 percent haircut on 100 million of Treasuries means roughly 98 million of cash changes hands.

Interest is not quoted as a coupon but embedded in the repurchase price. Dollar interest equals the cash principal multiplied by the repo rate multiplied by the number of days divided by 360 in most money markets. Overnight is the dominant tenor, but term repo out to several months exists. During the life of a term repo, adverse price moves trigger margin calls or collateral substitution, so the exposure is marked and topped up rather than left to drift.

Repo is the working capital of the fixed-income market. A dealer that buys a bond finances it overnight in repo, rolling the position daily; the carry is the bond's yield less the repo rate. Levered investors build positions the same way, buying a security and immediately repoing it to recover most of the purchase price.

Two pricing regimes coexist. General collateral trades reference any acceptable security within a class and track the broad money-market rate. When a specific bond is in heavy demand for shorting, it goes on special: the cash lender accepts a materially lower repo rate simply to obtain that bond. Structurally, most large-volume activity settles through tri-party arrangements where a clearing bank handles collateral valuation and substitution. Central banks operate in this market directly, and SOFR is constructed from overnight Treasury repo transactions.

Legal title to the securities passes to the cash lender, which is what makes the collateral enforceable in a counterparty default. Accounting, however, follows economic substance: because the seller retains the price risk and the coupon flows and has committed to repurchase, the securities generally remain recognised on the seller's balance sheet and a repo liability is booked against the cash received. The transaction therefore inflates both sides of the balance sheet and raises measured leverage.

This boundary has been exploited. Lehman Brothers' Repo 105 transactions were structured with haircuts large enough to qualify as true sales under the applicable rules, removing assets at quarter-end and understating leverage before the positions were reversed days later.

Expect to compute the repurchase price or the dollar interest from a repo rate, day count and term, and to work backwards from a haircut to the cash advanced. You should be able to identify which party is exposed to what: the cash lender bears counterparty credit risk mitigated by collateral, while the cash borrower bears the risk that collateral value exceeds the loan and is trapped in a default.

Equally important is explaining rate determination. Repo rates fall with higher-quality and more liquid collateral, shorter terms, physical delivery of collateral to the lender, strong counterparty credit and scarcity of the specific security. They rise when cash is scarce relative to collateral supply, which is precisely the stress dynamic tested in funding-liquidity questions.