Repo and Reverse Repo:

A repo transaction involves two legs of calculation. The first one is when cash and securities are borrowed and the second one is when they are returned at the end of the term. If a security pays a coupon during the term of the repo, the coupon should be appropriately distributed between the two parties because the lender of the securities held them all these days and deserves the major portion of it. Considering the above fact the settlement amount on the first leg involves the following two components.

Value of the securities at the transaction price. Accrued interest from the previous coupon date to the date on which the transaction is initiated.

The second leg involves the following three components.

Repo interest for the term of the repo. Accrued interest from the previous coupon date to the end of repo term. Return of principal amount borrowed.

Let us take a numerical example Trade date: 20th July 2004 Trade price: Rs1008.50 Face Value: Rs1,00,00,000 (10,000 bonds with a face value of Rs 1000 each) Security: 12.5% interest rate bond Last Coupon Date: 1st -July-2008 Repo rate: 7.5% Repo term: 2 days First leg: On 20th the seller of the repo (borrower of funds) receives the following sum: Value of the security: 1008.50*10000 = 1,00,85,000 Accrued interest: 12.5 * 1,00,00,000 * 19 /360 * 100 = 65,972.22 Settlement amount: 1,00,85,000 + 65,972.22 = 1,01,50,972.22 Second leg: On 22nd July the seller returns the following amount (repo period is two days): Original borrowing: Rs 1,00,85,000 Accrued interest: 12.5 * 1,00,00,000 * 21 /360 * 100 = 72,916.66 Repo interest: 7.5 * 1,00,00,000 * 2/360 * 100 = 4166.66 Amount to be returned: Rs 1,00,85,000 + 6944.44 + 4166.66 = Rs 10096111.1

Consider the scenario wherein a dealer thinks a particular securitys price is about to rise but he does not have the cash to buy that security, then he can borrow the cash from the repo market(say from a bank) in exchange for lending the security. The dealer is said to be doing repo in this case. Here the securities will be transferred to the account of the lending Bank. These securities will be repurchased by the dealer at the end of the term. At the end of the term if the price of the security is increased then he can sell the security in the market to convert into a cash profit. Carry Carry refers to the profit or loss that made out of a repo. For a repo transaction, a securitys carry is the Profit/Loss, exclusive of capital gain, earned by the security and financing it with repo. Other words, carry is the difference between the coupon interest earned and the repo interest paid. Carry can either be positive, negative, or zero. Positive carry When income from the asset being financed through a repo exceeds the cost of financing (i.e., repo rate plus expenses). Negative carry income from the asset being financed through a repo is less than the cost of financing. Zero carry income from the asset being financed through a repo is equal to the cost of financing. Reverse Repo A bank funds investors of stock market who feels that the current situation is suitable for investment but dont have the cash in hand. In this case the bank is said to be doing reverse repo. Actaully in these transactions there are two parties one is doing repo and the other one is doing reverse repo. But the transaction is called repo/reverse repo based on the initiator of the first leg. In the above example the shares are transferred to banks account. Usually banks lend only 70% (or less than 70%) of the funds required to avoid default risks. These are again transferred back to the investors. They are not popular in India.

Reserve bank controls repo rates and reverse repo rates as a measure of controlling liquidity and inflation. For commercial banks the major source of short term funding is Reserve Bank. Banks go short of money when there is a high demand for loans and the cash in hand at the banks is low. If RBI feels that the liquidity in the system is high and wants to make money more expensive it increases repo rate (The rate at which it lends to banks). Similarly if RBI feels there is a liquidity crunch in the market it reduces repo rate and hence the cost of money. On the other hand when the liquidity in the system is very high RBI borrows money from banks by offering lucrative interest rate (reverse repo rate). Banks would prefer to keep their money with RBI as the default risk is zero. Liquidity is contained in this way.

Money market is a part of fixed income market. It is a wholesale market. Fixed income market financial instruments with maturity period less than 1 year are traded in money market. Liquidity in money market is very high. From the point of view of liquidity, holding a money market security is as good as holding cash or money and hence the name. Money market is a collection of Over The Counter s (OTCs) where short term lending and borrowing happens. Many times the period of lending or borrowing is as short as over night. Most of the transactions in the money market are conducted by banks, central bank (reserve bank in India) financial institutions, Corporates and specialists. Banks use this market to cover their shortages by borrowing from other banks which have surplus short term money. In money market the bid rate is the borrowing rate and the offer rate is the lending rate of a bank. Inter Bank offer rate in London is called LIBOR and bid rate is called LIBID. The most common maturities in money market are 1 month,3 months, 6 months and 12 months. LIBOR is not the short term interest rate on GBP. It could be on any currency. The money market deals with different currencies and the LIBOR is specified for each currency that is available in money market. The LIBOR for a particular currency depends on the interest rates in domestic market of these currencies. This gives very less chances of arbitrage. The following instruments constitute money market

Treasury bills Certificates of Deposit Commercial Papers Call Money Repo

Yield curve, also known as, term structure of interest rates is a graph that shows relationship between yield or interest rates and maturity. Yield curve is plotted for bonds with similar credit rating but with different maturity dates. Yield of a bond inversely varies to time to maturity (tenor). Long-term bonds carry more risk of default and liquidity risk compared to shortterm bonds. Liquidity in short-term bonds is more because of less volatility in interest rates. Longterm bonds should offer short term interest rates plus risk and liquidity premiums. So usually yield of a 10 year treasury bond is more than that of a 1 year treasury bill. We can compare this with bank interest rates: banks offer more interest rate for long-term deposits compared to short-term deposits. In a yield curve maturity is plotted on x-axis and the corresponding yield values are plotted on y-axis. Yield curve tells us the market expectation of future interest rates, future economic growth and output. Yield curve influences bank rates and identifies arbitrage opportunities.

Effect of Discount Rate on Price of a Bond: It is obvious from the above formula that the discounting rate or market interest rate plays main role in pricing a bond. Higher the discounting rate or the expected rate of return, lower will be the price of a bond. In other words, if we purchase a bond at lower levels compared to other bonds with the similar profile in the market, you will get more rate of return on your investment. The conclusion is interest rates and bond prices move in opposite directions. The following statements hold good at the beginning of the bond period. A bond will sell at par value if the discounting rate is equal to the coupon rate. Note that discounting rate is the interest rate that could be earned by investing in alternative avenues in the market and the coupon rate is the interest rate offer by the bond. A bond will sell at above par if the discounting rate is lower than the coupon rate. A bond will sell at below par if the discounting rate is more than the coupon rate.

Interest gets accumulated as the time passes by till the time of coupon payment. Because of this accrued interest the price of a bond may be more than the par value even if the market interest rate is more than the coupon rate. The settlement price of a bond is the present value of future cash flows of the bond less accrued interest. The prices quoted in the market are without accumulated interest. This quoted price is called clean price. The settlement price or dirty price is the sum of clean price and the accumulated interest.

Effect of Maturity on Bond Pricing: Long term bonds are offered at lower prices compared to short term bonds.This is because the longer a bonds term to maturity, the greater the risk that there could be future increases in inflation. As the inflation increase the market interest rate increases. So the larger the current discount rate that is required the lower the bonds price.

Options: Consider a scenario. You track market dynamics and you come to know that interest rate is going to go down in next 3 months. The government wants to increase liquidity in the market to increase consumption. The logic that most Governments give is that if the interest rate is low, you will not put your money in banks as they offer lower deposit rates, meanwhile you spend some of the money or look for alternate investments. One investment option is stock market; but it is too risky for most of the people. Hence they invest in time tested assets, i.e. gold and land. We will look at gold in our case to show the meaning of option. Based on this analysis you conclude that gold demand will rise and hence prices of gold will also go up. How can you take advantage of the situation? What if you get the right to buy gold in 3 months at the rate of Rs 1100 per gram? The current rate is Rs 1090 per gram. You may have arrived at your conclusion that gold will rise above Rs 1100 per gram in 3 months. Of course, if the government doesnt lower interest rate, the gold prices may not even go beyond the existing Rs 1090 per gram in 3 months. Lets say you are not obligated to buy gold if it doesnt go beyond Rs 1100 per gram. This is a great situation to be in, isnt it? This is option for you, or more precisely call option. A call option is a right but not an obligation to buy an underlying asset at a specified price at a specified date. Consider one more scenario. You come to know that Government is going to increase the interest rate to tame inflation. Usually when the interest rates go up, people put their money in bank to avail high interest available. Corporates slow down their expansion plan because of high cost of borrowing. The market moderates and comes down. How can you take advantage of this situation? You will want to have right to sell your index option on a future date at a price determined now. Since you know the prices will go down, you go into a contract deciding the strike price (price at which the transaction takes place). If the price really goes lower than the strike price, you make money. If it doesnt, you have nothing to lose anyway as you bought the right to sell but you dont have to sell if you dont want. This is put option for you.In this case, you have right but not the obligation to sell an underlying asset at a specified price at a specified date. We will discuss options in detail in further articles. How do you get these wonderful rights to buy or sell but not the obligation? This is where you pay premium to buy this right. This premium or price you pay is known as option price. Index options and stock options are some of the most traded options in the stock markets around the world.