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repo market

Page history last edited by Brian D Butler 15 years, 1 month ago

 

Repo market - overview:

 

In repo transactions, securities are exchanged for cash with an agreement to repurchase the securities at a future date. The securities serve as collateral for what is effectively a cash loan and, conversely, the cash serves as collateral for a securities loan. There are several types of transactions with essentially equivalent economic functions - standard repurchase agreements, sell/buy-backs and securities lending - that are defined as repos for the purposes of the report. A key distinguishing feature of repos is that they can be used either to obtain funds or to obtain securities. This latter feature is valuable to market participants because it allows them to obtain the securities they need to meet other contractual obligations, such as to make delivery for a futures contract. In addition, repos can be used for leverage, to fund long positions in securities and to fund short positions for hedging interest rate risks. As repos are short-maturity collateralised instruments, repo markets have strong linkages with securities markets, derivatives markets and other short-term markets such as interbank and money markets.

 

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Implications of repo markets for central banks

 

repos by central banks, both as a monetary policy instrument and as a source of information on market participants’ near-term monetary policy expectations.

 

Repos are useful to central banks both as a monetary policy instrument and as a source of information on market expectations. Repos are attractive as a monetary policy instrument because they carry a low credit risk while serving as a flexible instrument for liquidity management. In addition, they can serve as an effective mechanism for signalling the stance of monetary policy. Repos have been widely used as a monetary policy instrument among European central banks and with the start of EMU in January 1999, the Eurosystem adopted repos as a key instrument. Repo markets can also provide central banks with information on very short-term interest rate expectations that is relatively accurate since the credit risk premium in repo rates is typically small. In this respect, they complement information on expectations over a longer horizon derived from securities with longer maturities.

 

Risks:

 

An assessment of the risks faced by repo market participants can help identify the conditions necessary for sound repo markets. Like other financial markets, repo markets are subject to some credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralised instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralisation of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default. Leverage that is built up using repos can increase these risks. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.

 

Repo markets have offsetting effects on systemic risk. They are likely to be more resilient than uncollateralised markets to shocks that increase uncertainty about the credit standing of counterparties, limiting the transmission of shocks. However, this benefit could be somewhat reduced by the fact that the use of collateral in repos withdraws securities from the pool of assets that would be available to unsecured creditors in the event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means they may help transmit shocks originating from this source. Finally, repos allow institutions to use leverage to take larger positions in financial markets, which could add to systemic risk.

 

 

CDS to measure risk:

 

Question:  what is a better measure of risk....spreads over German bund? or, sovereign credit default swaps (to measure default risk_? can they be different? where can you go to find this data?

 

Answer (thank you Aaron!):   There are several types of risks. The best measure of CREDIT risk is found in credit default swap spreads. This would be your best indicator of DEFAULT risk because a CDS only prices in the chance of a credit event occurring. If you think Spain has a better chance of defaulting than Germany, like I do, you would expect the CDS trading on Spain to be greater than Germany. It is, 5-year Spanish CDS is 141 bps while 5-year German CDS is 57.5 bps, a difference of 83.5 basis points. This means it costs $8,350/year more to insure $1 million of Spanish debt vs German debt.

 

The difference in CREDIT risk has to show up in the current yields or there would be an arbitrage opportunity. Generic Spanish 5-year debt is trading 106 basis points above German debt. The extra 22.5 basis points probably are due to LIQUIDITY risks, German bunds are more liquid and therefore get a liquidity premium; and maybe more importantly, FINANCING risk. For a leverage player it probably costs more (reflected in a repo rate) to borrow against Spanish debt than German debt. Or borrowing against Spanish debt uses more capital (reflected in larger haircuts).

 

For DEFAULT risk use CDS. 

 

 

 

 

 

 

Links: 

more:  risk  and Credit Default Swap (CDS) market

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