ACI Dealing Certificate: Cash Money Markets

2 Cash Money Markets

Overall Objective: To understand the function of the money market, the
differences and similarities between the major types of cash money market
instrument and how they satisfy the requirements of different types of borrower
and lender. To know how each type of instrument is quoted, the quotation, value
date, maturity and payment conventions that apply and how to perform standard
calculations using quoted prices. Given the greater inherent complexity of repo, a
good working knowledge is required of its nature and mechanics.

At the end of this section, candidates will be able to:

 define the money market

 describe the main features of the basic types of cash money market
instrument --- i.e. interbank deposits, bank bills or bankers' acceptances,
treasury or central bank bills, commercial paper, certificates of deposit and
repos --- in terms of whether or not they are securitized, transferable or
secured; in which form they pay return (i.e. discount, interest or yield); how
they are quoted; their method of issuance; minimum and maximum terms;
and the typical borrowers/issuers and lenders/investors that use each type
 use generally-accepted terminology to describe the cash flows of each
type of instrument
 understand basic dealing terminology as explained in The Model Code
 distinguish between and define what is meant by domestic, foreign and
euro- (offshore) money markets, and describe the principal advantages of
euromarket money instruments
 describe the differences and similarities of classic repos and sell/buy-
backs in terms of their legal, economic and operational characteristics
 define initial margin and margin maintenance
 list and outline the main types of custody arrangements in repo
 calculate the value of each type of instrument using quoted prices,
including the secondary market value of transferable instruments
 calculate the present and future cash flows of a repo given the value of the
collateral and an agreed initial margin
 define general collateral (GC) and specials
 describe what happens in a repo when income is paid on collateral during
the term of the repo, in an event of default and in the event of a failure by
one party to deliver collateral

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Introduction
A loose definition of the “Money Market” is that it “includes wholesale
debt instruments with an original maturity of 12 months or less”. Interest on
these instruments is usually calculated on a simple interest basis and is
(usually) payable on maturity.
(It should be noted however, that there are longer term money market
instruments e.g. a 2 or 5 year CD or Eurodeposit.)

1. Market Sources for Funding

A borrower can essentially obtain funding in 3 different and distinct
money markets – the domestic market, the foreign market and the euro –
market. Each option has apparent advantages and disadvantages.

1.1 The Domestic Money Market:

This, as the name implies is the cash market within one’s own country,
denominated in one’s own currency e.g. $ in the USA, ₤ in the UK, € in
“Euroland” etc.

Advantages:
 It is local and therefore the borrower will be known to potential
lenders
 Easy to access
 (Generally speaking) a plentiful supply of cash
 Relatively simple settlement and clearing procedures

Disadvantages:
 (Possibly) high interest rates
 Finite amount of cash available especially for large parcels of
borrowings
 Possible credit constraints
 Lack of diversification (all eggs in one basket)

1.2 The Foreign Money Market:

Not to be confused with the foreign exchange market! A borrower would
utilize the foreign market in order to raise funds in a foreign currency i.e. a
currency other than the domestic currency. This could be favourable
when one has a foreign currency commitment or when the domestic
currency is (temporarily) relatively weak in relation to the foreign currency

Advantages:
 Potentially lower rates of interest
 A far larger market than the domestic market
 Diversification of borrowings

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 Could potentially convert to large sums of local currency relative to

the actual foreign currency liability.

Disadvantages:
 Currency risk
 Unless the borrowing entity is well known, favorable credit lines
could be a problem
 Initially may appear to be attractive viz. interest rates, but after
hedging currency exposure could prove to be quite costly

1.3 The Euro Money Market:

Not to be confused with the market in which the Euro (€) is the domestic
currency! A euro-currency can be generally defined as a currency
owned by a non-resident of the country in which that currency is legal
tender. The Euromarket is therefore the market in which these (euro)
currencies are traded. E.g. $’s held by Europeans, ₤’s held in the US or in
Europe etc.

Advantages:
 Potential for favourable interest rates
 No currency risk as with foreign loans

Disadvantages:
 Unless the borrowing entity is well known favourable credit lines
could be a problem
 Possible limitation as regards quantum, but this depends on the
currencies involved.
 “Complicated” settlement procedures

Please note that the advantages and disadvantages as listed above are
by no means exhaustive. Class discussions will highlight a number of others
that are not listed but are nevertheless relevant.

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2. Money Market Products and Instruments

The term “money market” usually applies to loans, deposits and
instruments with a tenor or remaining “life” of 1 year or less. This coincides
with the “official” ACI definition (and is the answer required should it be
asked in the exam!) However, please note that in a number of
jurisdictions, the money market extends to as long as 3 years. The
underlying instruments are essentially evidential confirmation of a
borrowing/lending transaction involving 2 parties – the
borrower/seller/issuer and the lender/buyer/investor.

BASIC TYPES OF MONEY MARKET INSTRUMENTS:

INSTRUMENT UTILISED BY? SECURED TRANSFERABLE DISCOUNT/ TENOR

YIELD
Overnight or Banks Usually Non Yield in the O/n – 5
Term unsecured transferable form of years
Deposits interest
Certificates Banks Unsecured Transferable: Yield (or Up to 5
of Deposit by delivery (if discount years*
(NCD or CD) bearer CD) or to yield
endorsement basis in the
form of a
Zero
Coupon
CD)
Commercial Corporates Usually Transferable ECP and Commercial
or Corporate unsecured by delivery as GBP CP on paper is
Paper it is usually in a yield usually short
(Also referred bearer form. basis** term, whilst
to as “One USCP on a Corporate
name discount paper is for
Paper”) to yield longer
basis periods***
Bills of Corporates Unsecured Transferable: Discount Usually 90 –
Exchange/ by to yield 120 days
Bankers endorsement basis
Acceptances
(BA’s)
Treasury Bills Government Unsecured Transferable: Discount 13 weeks,
(TB’s) Via Central by delivery to yield 26 weeks,
Bank or the basis in 52 weeks
Debt USD and (France 4 –
Management GBP. 7 weeks)

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Office (DMO) Elsewhere

for GBP TBs quoted as
a yield but
issued on
a discount
to yield
basis
Repurchase All Market Secured Non Yield o/n to 6
Agreements Participants transferable months
* For Eurodollar deposits longer than 1 year interest is paid on an annual
basis. For odd period deposits longer than 1 year, the odd period portion
of the coupon is paid at the end of the deposit.

** Euro commercial paper, ECP, is always advertised as a yield but is

issued at a discount to yield basis.

*** In the US CP is seldom issued for periods longer than 270 days as paper
issued in excess of this period must be registered with the SEC.

NOTE: A number of the instruments have more than 1 common name or

abbreviation. The text below reflects these different terms.

2.1 Overnight or Term/Time Deposits

This is the simplest of the money market products. Money is deposited at a
bank on an overnight basis or for a fixed period of time e.g. 1 month or 32
days etc. Overnight deposits attract a variable rate of interest, meaning
that rates can change from day to day. Term or time deposits on the
other hand attract a fixed rate of interest for the period of the deposit.
These products are not transferable from one party to another and so
cannot be liquidated before maturity. In other words if Mr. X has a 3-
month fixed deposit in his name, he cannot transfer ownership of these
funds to Mr. Y. This can only be done when the deposit matures. Interest is
calculated daily but is usually only payable at month end or when the
deposit matures. Time deposits could be for periods as short as 7 days or
as long as several years. The interest calculation, either simple or
compound interest is dependent on the period as well as the quotation. A
one-year fixed deposit can attract an interest rate of 12.5% p.a. or 11.40%
n.a.c.m.

If the deposit is made in the domestic currency, then settlement takes

place on the same day. If the deposit is in a foreign currency then
settlement is in 2 working days time or t + 2.In other words in the UK a GBP

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deposit will settle on the same day, but a Eurodollar deposit will only settle
in t+2.

If a Euro deposit e.g Eurodollar, Euroyen etc term deposit is made for a
period of 15 months - interest is payable annually. Interest will be paid at
the end of the first year and then on a pro rata basis i.e. 3 months interest,
thereafter at maturity.

2.1.1 Math of Time or Term Deposits

Example 1:
If you invested GBP 100 000 for a period of 1 year, what is the maturity
proceeds or future value (FV) if you had earned interest at a rate of:
i) 10% p.a.?
ii) 10% n.a.c.m.?

Answers:
i) For this answer you can use either 1 of the following 2 formulae:

  dias  
Valor Acumulado  Valor Investido x 1   i x 
  base  

and

VF = VP 1  i 
n

Therefore:

i)
  365  
Valor Acumulado = GBP 100 000 1  10% x 
  365  

= GBP 110 000

Ou

VF= GBP 100 000 1  10%i 

1

= GBP 110 000

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ii) For this part of the question you should use the second formula!
Alternatively, you could convert the monthly rate to an annual rate and
then proceed as for 2.1.1. However, using the second formula is more
straightforward, hence:

II)
12
 10% 
VF = GBP 100 000 1  
 12 
= GBP 110 471, 31

2.2 Certificates of Deposit (CD’s or NCD’s)

A Certificate of Deposit (CD) is also referred to as a Negotiable Certificate
of Deposit (NCD).It is, in reality, nothing more than a negotiable fixed
deposit. Only banks may issue CD’s. In 1.1 above it stated that (ordinary)
time deposits are non-negotiable and therefore non-transferable. NCD’s
are, as the name implies, negotiable and therefore transferable. CD’s are
issued for periods up to a maximum period (in the UK) of 5 years. The rates
quoted are on a yield basis and for the shorter-term CD’s i.e. less than 1
year, the quantum of interest is usually calculated on a simple basis and
payable on the maturity of the CD.

  days  
Pr oceeds at Maturity  Face value x 1   rate x 
  base  

Longer dated CD’s usually pay interest (coupon) on an annual basis,

which is similar to a Eurobond. The amount of the coupon payable in
each period depends upon the interest rate convention used e.g.
ACT/ACT or ACT/365 or 30/360 etc. Please note that in certain countries
longer dated CDs would pay interest on a semi annual basis, so please
take note of the day-count convention for that particular jurisdiction. For
Euro-currency deposits (e.g. Eurodollars), coupons are paid on an annual
basis. When the tenor is an odd period e.g. 15 months, 18 months or 30
months etc, then a full coupon is paid after 12 months (or multiples
thereof). The final coupon will be paid, on a pro rata basis, at the end of
the “odd” or broken period. Therefore for a 30 month CD there will be 3
coupon payments – (full coupon) after 12 months and 24 months and
then ½ coupon after 30 months.

Certificates of deposit can be registered in the name of the client or in

bearer form. If it has been registered in the name of the client, then

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transfer takes place by way of endorsement, whereas if it is in bearer form,

transfer takes place by simple delivery.

A typical broker’s screen for advertising CD’s would look like:

Eurodollar CD’s

1 MONTH 4.50 – 40 2X6

2 MONTHS 4.60 – 50 3X2
3 MONTHS 4.65 – 55 1X6
6 MONTHS 4.95 – 85 4X3

Note:
 4.60 – 50 means that the market maker bids for 2 month paper to
give a yield of 4.60% and offers 2 month paper so as to give the buyer
a yield of 4.50%. The difference between the Bid price and the Offer
price is called the “spread” – in this case 10 basis points.
 The big figure of 4% is called the handle and the small figures (60-50)
are referred to as the basis. When one dealer quotes another dealer
he will often simply quote the basis.
 3 x 2 means that there are $2m available on the offer and that the
market maker is bidding for $3m.
General Comment: When a bank bids for “paper” this is equivalent to
the bank investing funds, and will therefore try to obtain the highest
rate possible. Conversely when a bank offers “paper” this is the
equivalent to the bank borrowing funds or taking in a deposit, and will
therefore try to pay the lowest rate possible.

Contrast this to when a bank bids for “cash” which is the same as a
bank wanting to take in a deposit –they will try to take cash in at the
lowest rate possible! Conversely when a bank offers “cash” they will
try to obtain the highest rate possible!

Paper transactions:
Quoted rates: 6.40/50
Bank bids for Paper High @ 6.50%
Bank offers Paper Low @ 6.40%

Cash transactions:
Quoted rates: 6.40/50
Bank bids for Cash Low @ 6.40%
Bank offers Cash High @ 6.50%

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2.2.1 Math of CD’s (and other yield instruments)

Example 2:
You purchase a 9 month CD in the primary market with a face value of
USD5 000 000, at par of 4.8 %.( Day count convention: 30/360 basis.)

i) What is the maturity value of the CD?

ii) If you trade out of these CD’s 25 days later at a rate of
4.75%, what were the secondary market proceeds?

Answers:
i)

  dias  
Re ceitas / Valor na Maturidade  Valor Facialx 1   i x 
  base  

  270  
Receitas na Maturidade =USD 5 000 000 1   4.8% x  
  360 
= USD 5 180 000

NOTE: Days to maturity are 270 because each month has,

according to the day count convention, 30 days.

ii) If you trade out of these CD’s 25 days later at a rate of

4.75%, what are the secondary market proceeds?

Valor na Maturidade
Valor no Mercado Secundário 
 Dias para o Vencimento 
1  i x 
 base 
USD 5 180 000
Valor no Mercado Secundário =
  245  
1   4.75% x 
  360  

= USD 5 017 792.88

Valor na Maturidade
Dias para o Vencimento

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NOTE: The number of days in the denominator is 245 as we

always consider DAYS TO MATURITY and not days gone by!

Example 3:
A trader purchases a GBP10 000 000 CD in the primary market. The tenor
of this CD is 182 days and was purchased at par of 6.35%. What was the
maturity value of these CDs?

Answer:

  days  
Pr oceeds at Maturity  Face value x 1   rate x 
  base  

  182  
Maturity proceeds/value = GBP10 000 000 1   6.35% x 
  365  
= GBP 10 316 630.14

Example 4:
CDs with a maturity value of GBP 2 100 000 were initially issued for a period
of 1 year.
i) What was the original rate of issue if the face value of these CDs
was GBP 2 000 000?
ii) What is the current market value of these CDs if the remaining
period to maturity is 60 days, and that the current 2 month rate is
6%?

Answers:
i)

  days  
Pr oceeds at Maturity  Face value x 1   rate x 
  base  

  365  
 2 100 000 = 2 000 000 x 1   x % x 
  365  
  2 100 000   36500
 x =     1 x
  2 000 000   365
 x = 5%

OR

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Using the formula in Basic Interest Rate Calculations page 13 –

which is what I would recommend!

Interest Earned x Day Base x 100

Annualised Return = Amount Invested Investment Period
Period
100 000 36500
x = 5%
2 000 000 365

ii)
Maturity value
Secondary market value 
 days remaining to maturity 
1   yield x 
 base 

2 100 000
Secondary market proceeds =
  60  
1   6% x 
  365  
= GBP 2 079 489.96

2.2.1.1 Accrued Interest

The CD referred to in example 4 was purchased for GBP 2 000 000. The
maturity value is calculated to be GBP 2 100 000.00. In other words the
amount of interest to be earned over the “life” of the CD is GBP 100 000.
This interest will be earned on an even or straight line basis over the life of
the asset i.e. GBP 100 000 over 365 days or GBP 273.97 per day!

Example 5:
A dealer purchases a EUR 10 000 000, 180 day CD at par of 4%. After
holding it for a period of 30 days she sells it at a yield of 3.9%.

i. How much did she sell the CD for i.e. what were the secondary
market proceeds?
ii. Did she make a profit or loss on the sale of this CD?
iii. What was the “holding period return” or “return on investment” on
this CD?

Answers:
i. You must first calculate the maturity value in the primary market
and then calculate the secondary market proceeds.

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  180  
Maturity value = EUR 10 000 000 x 1   4% x 
  360  
= EUR 10 200 000
10 200 000
Secondary market proceeds =
  150  
1   3.9% x 
  360  
= EUR 10 036 900.37
ii. The original “life” of the CD was 180 days. The amount of interest to
be earned over this period is EUR 200 000. Therefore the amount of
interest to be accrued on a daily basis is
200 000
= EUR 1 111.11 per day
180
The CD was held for 30 days, therefore the total interest accrued to
date is:
30 x EUR 1 111.11 = EUR 33 333.33
The selling price was EUR 10 036 900.37 and the book value is EUR
10 033 333.33. The profit (or loss) on the sale of this CD is:
Selling price – book value
 EUR 10 036 900.37 – EUR 10 033 333.33 = EUR 3 567.04

iii. From the formula in Basic Interest Rate Calculations page 13

36 900.37 36000
x = 4.43%
10 000 000 30

Example 6:
One day after purchasing the CD as referred to in example 4 the dealer
decides to sell it in the secondary market. The best bid that he receives is
5% - exactly the same yield at which the CD was purchased.
i) Did the dealer receive more or less than what he paid for the CD?
ii) Did the dealer make a profit or loss or did he break even on this
trade?

Answer:
2 100 000
i) Secondary market purchase price =
  364  
1   5 % x 
  365  

= GBP 2 000 260.96

The dealer received more than what he paid for the CD!
(Remember he paid GBP 2 000 000)

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ii) The CD had been held for 1 day. Interest in the amount of ₤
273.97 had therefore accrued. The book value of the CD is
therefore GBP 2 000 273.97 at the time of the sale. He only received
GBP 2 000 260.96! The dealer therefore made a trading loss of
(GBP 2 000 260.96 - GBP 2 000 273.97) = - GBP 13.01. A small loss, but
a loss nevertheless.

General Comment: When a CD is sold in the secondary market, the

proceeds from the sale will, more often than not, be more than the
purchase price of the CD. This does not however mean that a profit was
made on the sale! One must take accrued interest into account in order
to ascertain the book value of the asset – thereby determining the profit
or loss on the sale. A general rule of thumb is that if a CD is purchased and
sold at the same yield, but on different days, this will result in a loss on the
trade.

Example 7:
Calculate the final amount of interest to be received on a 21 month
Eurodollar CD issued at par of 3.75%. The face value of the CD was USD
5m

Answer:
For Eurodollar deposits longer than 1 year interest is paid on an annual
basis. For odd period deposits longer than 1 year, the odd period portion
of the coupon is paid at the end of the deposit!

9
Last coupon will be 3.75%% x USD 5 000 000 x = USD140 625
12

2.3 Commercial or Corporate Paper

Commercial paper or CP is issued by a corporate in much the same way
that a bank issues a CD. Only banks may take in deposits and therefore
only banks can issue CD’s. In order for a corporate to raise short-term
finance in its’ own name it can issue Commercial Paper (to raise long term
finance a corporate would issue Corporate Paper.)This process (of
bypassing the banks) is known as “disintermediation”.

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Intermediation

Borrower or Investor or
Bank
Deficit Unit Surplus Unit

Disintermediation

When an investor purchases a CD, he is essentially comfortable with the

credit worthiness of the issuing bank. With CP, the credit risk lies with the
corporate itself. Higher rated companies can raise finance at cheaper
rates than lower rated companies. Not all companies can issue CP, as
they are not perceived to be credit worthy by the investing public. In such
cases the investor would prefer to see an intermediary, such as a bank,
taking on the credit risk of the corporate. CP is issued either on a discount
(to yield) or on a yield basis.

The particulars of the commercial paper to be issued by the corporate

are detailed in a commercial issuing program. This means that they would
indicate how much they intend raising and over what period of time. In
other words they will not raise all the finance (i.e. issue all the CP) required
at once, but will rather issue paper when it is required over a period of
time. It is for this reason that it is said that CP is constantly being issued.

In the US, CP is issued for periods up to 270 days, with the majority of issues
in the very short term. US CP is issued on a discount (to yield) basis.

 days 
Discount amount  Face Value x  dis rate x 
 base 

Euro-commercial Paper, ECP, is similar to US CP but with 2 important

differences! Firstly, the period of issue can extend to 365 days, with the
majority of issues between 30 and 180 days. Secondly, whilst ECP trades
on a discount it is quoted on a yield basis.
Maturity value
Secondary market value 
 days remaining to maturity 
1   yield x 
 base 

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General Comment: Discount to yield basis refers to a discount instrument

being quoted on a yield basis but still traded at a discount!

2.4 Bills of Exchange

A company uses a bill of exchange in order to raise finance for trade
purposes. The party raising the finance i.e. the borrower is known as the
“drawer” of the bill. Usually a bank stands as the guarantor to the drawer
and is referred to as the “acceptor” or “drawee” of the bill. This type of bill
is known as a “banker’s acceptance”. In the UK, if the accepting bank is
one on a specific list published by the Bank of England, the bill becomes
an “eligible bill”. This means that this bill can be discounted by the Bank of
England, and will therefore command a lower yield than an ineligible bill.
The tenor of a bill of exchange is anything from 7 days to 1 year, with the
most “popular” period being 3 months. They are issued and quoted on a
discount basis, although in certain parts of the world they are quoted on a
discount to yield basis. Bills of exchange are negotiable instruments. The
investor’s/buyer’s risk on this instrument resides with the accepting bank
and not with the drawer of the bill. Contrast this with CP where the risk
resides with the issuing company! The purchaser of a bill of exchange (in
the secondary market) is known as the “payee” of the bill.

2.5 Treasury Bills (TB’s or T-Bills)

Treasury bills are short-term instruments issued by a government in order to
raise (short term) finance. They play an important role within the money
market as they represent the short-term risk free rate within the market.
TB’s should be “risk free” as they represent a debt obligation of the
government, supposedly the highest domestic credit rating within a
country. Please remember, however, that there is no such thing as “risk
free” – there is always (credit) risk!! It may be small but there is a risk of
non-payment on maturity. Domestic Treasury Bills are issued all around the
world, each country having its own nuances. The usual tenor for TB’s is 13
weeks, 26 weeks or 52 weeks. Theoretically, tenors are stated on a
“weeks” basis rather than on a “days” basis as they normally offered for
tender on a set particular day of the week e.g. every Wednesday, or
every Friday. They will therefore mature 13 weeks later on a Wednesday or
Friday etc. In practice however, traders talk about a “91 day TB” etc. T-Bills
are issued at a discount and usually quoted as such. However, in certain
countries they may be issued at a discount but quoted on a yield basis.

A typical “run” of rates for UK T-Bills:

19/8 5.55 - 50 25 x 15

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26/8 5.58 - 55 10 x 15
02/9 5.60 - 55 10 x 5
09/9 5.64 - 63 15 x 30
16/9 5.70 - 62 10 x 20
23/9 5.73 - 68 5 x 15
30/9 5.76 - 72 10 x 10

Note:
 5.70 - 62 means that the market maker bids for TB’s maturing on
16/9/xx at a (discount) rate of 5.70% and offers TB’s maturing on
16/9/xx at a (discount) rate of 5.62%. The difference between the Bid
price and the Offer price is called the “spread” – in this case 8 basis
points.
 The big figure of 5% is called the handle and the small figures (70-62)
are referred to as the basis. When one dealer quotes another dealer
he will often simply quote the basis.
 10 x 20 means that there are ₤20m available on the offer and that
the market maker is bidding for ₤10m.

2.5.1 Math for Treasury Bills (and other Discount Instruments.):

Example 8:
A 90-day US T-bill is at a (discount) rate of 5.4%. The face value being
USD 1 000 000

i) What was the price of the T- bill?

ii) What was the discount amount?
iii) What was the equivalent true yield of this instrument?
iv) What would the price be of a USD 1 000 000 90 day US T-bill
quoted at a yield of 5.474%?

Answers:
i) What was the price of the T- bill?

  days  
Market value  Face value x 1   Dis rate x 
  base  

Remember: The formula for the price of a discount instrument is the

same, whether it is purchased in the primary or secondary market.

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  90  
Price = USD 1 000 000 1   5.45% x 
  360  
= USD 986 500

ii) What was the discount amount?

 days 
Discount amount  Face Value x  dis rate x 
 base 

90
Discount = USD 1 000 000 x 5.4% x
360
= USD 13 500

iii) What was the true yield of this instrument?

Discount rate
True yield 
 days 
1   Discount rate x 
 base 

5.4%
True Yield =
  90  
1   5.4% x 
  360  

= 0.05474 or 5.474%

NOTE: The true yield rate must be higher than the discount rate. This is
always the case! If your calculation produces a lower rate then you have
“added” in the denominator and not “subtracted”.

iv) What would the price be of a USD1 000 000 90 day US T-bill
quoted at yield of 5.474%?

Maturity value
Secondary market value 
 days remaining to maturity 
1   yield x 
 base 

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USD 1 000 000

Price =
  90  
1   5.474% x 
  360  

= USD 986 500 (or USD 986 499.75 to be exact!)

Example 9:
GBP 7 000 000, 91 Day TB’s are issued for an amount of GBP 6 916 230.14.
i) What was the discount in monetary terms?
ii) What was the discount in % terms?
iii) What was the true yield of this issue?

Answers:
i) Discount amount = Face Value – Consideration
= GBP 7 000 000 - GBP 6 916 230.14
= GBP 83 769.86

Discount Day Base

ii) Discount in % terms = x
Face Value Tenor
83 796.86 365
= x
7 000 000 90
= 0.048 or 4.8%

NOTE: This calculation is not tested in the exam!

iii) Discount rate

True yield 
 days 
1   Discount rate x 
 base 
4.8%
True Yield =
  91  
1   4.8% x  
  365 

= 4.858%

NOTE: The yield is higher than the discount rate!

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3. Repurchase Agreements (REPOS)

A repurchase agreement is an agreement in which a security is sold and

later bought back at an agreed to or predetermined price.
(A Concise Dictionary of Business – Oxford Reference)

Repurchase agreements are used by central banks to either introduce

cash into the market or to take cash out of the market. When a bank is
short of funds and is unable to borrow these funds in the interbank market,
it will borrow cash from the central bank by way of a repurchase
agreement. When there is too much cash in the market, the central bank,
as a consequence of monetary policy, carries out a reverse repo, thereby
draining cash from the market. Repos and reverse repos involving the
central bank are usually referred to as “system repos.”

We can refine our definition of a repo to:

“A repo agreement is a transaction in which one party sells securities to
another, and at the same time and as part of the same transaction
commits to repurchase identical securities on a specified (future) date at
a specified price. The seller delivers securities and receives cash from the
buyer. The cash is supplied at a predetermined rate – the repo rate – that
remains constant during the term of the trade. On maturity the original
seller receives back collateral of equivalent type and quality, and returns
the cash plus repo interest. Although legal title to the securities is
transferred, the seller retains both the economic benefits and the market
risk of owning them.”
Source: An Introduction to Repo Markets – Moorad Choudhry

In essence a repo is a (cash) borrowing or funding transaction. The term

repo is actually a generic term that includes 2 different types of
transactions:

 Classic or US – Style Repos (known in France as pension livree), &

 Sell and buy backs agreements

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Data do Fundos (2)

Inicio

Activo (1)
PARTE A PARTE B
Tomador de Fundos/ Emprestados dos Fundos /
Comprador do REPO
Vendedor do REPO
Activo (4)

Data do Fundos + Juros (3)

Vencimento

In order for the transaction to be termed a true “repo” certain documents

must be signed by both parties. (See 3.4) In essence the documentation
protects the repo buyer in the case of a default by the repo seller. Should
the repo seller default the repo buyer can dispose of the collateral in
order to recoup his funds. It should be noted that if the collateral were
merely “pledged”, it is more than likely that the repo buyer would not be
able to liquidate the collateral but would have to wait until insolvency
proceedings were complete. The repo buyer would be considered to be
a concurrent and not a preferred creditor. Transferring legal title to the
collateral also allows the buyer to use the repo to cover a short position in
securities.

A reverse repurchase agreement (or reverse repo as it is commonly

known) can, on the other hand be described in 2 different ways. Firstly it
could be viewed as exactly the same arrangement but from the lender’s
(repo buyer’s) perspective. Alternatively, it can also be used to describe
the situation where one party has “shorted” the scrip (and is therefore
long of cash) and needs to borrow the scrip for onward delivery. The repo
initiator uses cash as collateral in order to borrow a particular or specific
bond. This is also referred to as a “special” repo and is described in more
detail under 3.5 below.

As repos are “secured” transactions they should normally trade below the
Fed Funds or standard call rate (which is unsecured.)

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An example of a repo trader’s screen would look something similar to:

7% 20201

O/N 2 6.28 – 6.203 10 X 54

1 WK 6.25 X 20
1 MNTH

GC5

O/N 2 6.75 – 6.703 100 X 754

1 WK 7.00 - 5
1 MNTH 7.10 – 7.00 20 X 20

KEY:
1 = 7% 2007 Bond
2 = Period of repo (overnight, 1 week, 1 month etc)
3 = Repo rate: The trader will purchase the repo (i.e. lend cash) @ 6.28%
and sell the repo (borrow cash) @ 6.20%
4 = 10 x 5 indicates that the trader is prepared to buy 10m nominal and
sell 5m nominal of the 7% 2007 bond
5 = General Collateral

General Comment: Referring to the rates as quoted on the screen as

illustrated above. The bid rate (in the 1 month GC repo) is 7.10%, whilst the
offer rate is 7.00%. When we refer to the terms bid or offer in the repo
market we make reference to the bidding for, or offering of securities and
not cash!

3.1 Basic Terminology

In the diagram (on page 17) Party A is known as the seller of the repo
whilst Party B is the buyer of the repo. In other words the seller “sells” the
collateral and thereby borrows cash. The buyer on the other hand “buys”
the collateral and thereby lends cash. In Party A’s books this is referred to
as a “repo”, whilst in Party B’s books this same transaction is referred to as
a “reverse repo”. Put another way, when one is borrowing cash, then this is
termed a “repo”. When one is lending cash, then this is termed a “reverse
repo”.

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3.2 Repo Rates

As can be seen from the diagram on page 20, there are 2 parties involved
in a repo. One of the parties will always be the “price maker”, with the
other party being the “price taker”. Remember that it is a “fact of life”
that the price maker always gets the “best” price whilst the price taker
always gets the “worst” price! Also, as can be seen from the diagram, 1
party will be borrowing funds and the other party will be lending the funds.
This then leads to 2 questions:
 How does one distinguish between a price maker and price taker?
 How do you know if you are borrowing or lending cash?

The key phrases are as follows:

“You quote” = you are the price maker
“You are quoted” or “you receive a quote” = you are the price taker
“You agree to do a repo” = you are borrowing money
“You agree to reverse in”, or “do a reverse repo” = you are lending
money.

Example 10:
Given the following rates for a repo – 3.25%/3.75%
You would then use the following rates in the following circumstances:

Repo Reverse
Repo
You Quote 3.25/3.75 3.25% 3.75%
You are quoted 3.25/3.75 3.75% 3.25%

3.3 Types of Repos

The standard or default value date for a repo transaction in a particular
currency will be the same as the usual value date in the interbank deposit
market for that currency.

Spot: When dealing in your own currency in your own country then spot is
today (t+0). When dealing in a foreign currency in your own country then
spot is generally 2 banking days from today (written as T + 2)

There are 3 basic types of repurchase agreements:

i) Open or Demand repos: This agreement continues until one of the
party’s requests that it should come to an end.
ii) Short dated repos: Usually for periods shorter than 30 days. This is
the most common type of repo.
iii) Term repos: The period of the agreement is stated at the start of
the contract. This is usually for periods in excess of 30 days and

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could be as long as 6 months. Due to the longevity of the

agreement, the seller may not want to “encumber” specific assets
for that long a period. A “right of substitution” clause may be
included in the contract. This clause allows the seller to substitute
or change the collateral assets during the period of the
agreement.

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3.4 Comparison between a Classic Repo, Buy and Sell Back

and Securities Lending Transactions:

Classic Repo Buy & Sell-Back Securities

Lending
Basis of Cash v Securities Cash v Securities Securities v
Transaction Securities or any
other
acceptable
collateral
including a Letter
of Credit
Documentation Usually GMRA, Separate Usually OSLA,
allowing set off transactions, allowing set off
therefore no
agreement
necessary
Coupon Returned to Kept by Buyer Returned to
Payment Seller Lender
Fee/Cost Quoted as a Quoted as a Quoted as a fee
repo rate, and repo rate, and and paid on
paid as interest paid as price maturity. Should
differential be set off against
between selling cash rate if cash
and forward used as collateral
repurchase price
Margin Rights Initial and Initial margin Initial and
variation margin possible. variation margin
are both Variation margin are both possible.
possible. only possible
through a new
transaction.
Substitution Possible Possible only Possible
through a new
transaction
Maturity Fixed or open Fixed only Fixed or open

3.5 Documentation
“Where sale and repurchase agreements or stock borrowing or lending
transactions are entered into, proper documentation including written

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agreement of key terms and conditions should be in place prior to the

consummation of any trades” – The Model Code

There are a number of generally accepted documents covering these

transactions. The 2 most “popular” and frequently used are:
i. PSA/ISMA The Global Master Repurchase Agreement – PSA/ISMA
GMRA (or TBMA/ISMA GMRA)
This agreement was developed jointly by the Public Securities
Association (PSA) - which has been renamed The Bond Market
Association (TBMA) – and the International Securities Market
Association (ISMA).This document is now the market standard
agreement for repos as well as sell and buy back transactions. The
key features of this agreement are:
 Repo trades are structured as outright sales and repurchases;
 Full ownership is conferred of securities transferred;
 There is an obligation to return “equivalent” securities;
 There is a provision for initial and variation margin;
 Coupon is paid over to the repo seller at the time of the
payment;
 Legal title to collateral is confirmed in the event of default.

The main advantages of this agreement are i) its’ allowance for

close – out and netting are capital efficient for CAD purposes, ii) its’
specifying action in the event of default and iii) its’ rules on
margining.
Source: An Introduction to Repo Markets – Moorad Choudhry

ii. The Gilt Repo Legal Agreement

The Gilt Repo Legal Agreement is an amended version of the
PSA/ISMA GMRA for the UK gilt repo market. The Gilt Repo Code of
Best Practice which was issued by the Bank of England strongly
advises participants in the repo market in the UK to adopt this
agreement. This agreement provides for, inter alia:
 The absolute transfer of title to securities;
 Daily marking to market;
 Appropriate initial margin and for maintenance of margin
whenever the mark – to – market reveals a material change
in value;
 Clear events of default and the consequential rights and
obligations of the counterparties;
 In the event of default, full set-off of claims between
counterparties;
 Clarification of rights of parties regarding substitution of
collateral and the treatment of coupon payments;

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 Terms subject to English law.

Source: An Introduction to Repo Markets – Moorad Choudhry

Other documents include:

iii. ESLA : Equities Stock Lending Agreement
iv. ISLA: International Securities Lenders’ Association
v. OSLA: Overseas Securities Lenders’ Agreement
vi. GMSLA: Global Master Scrip Lending Agreement

3.6 Types of “Collateral”

It is important to note that there are 2 types or classes of collateral. The first
is referred to as General Collateral or GC and the second as a Specified
Collateral repo. The latter is simply or commonly referred to as a “special”.
Where the repo is driven by the buyer’s need i.e. their willingness to
lend/invest cash, the exact nature of the collateral is not that important -
provided it is of a decent credit quality of course! General collateral
therefore means that the lender is indifferent as to which security is
received as collateral. Where the repo is driven by the buyer’s need to
borrow a specific security (due to the fact that he has short sold this
security and needs to borrow it for onward delivery) this is known as a
special. A seller who is aware that the security being requested by the
buyer is in particular short supply is able to negotiate a lower interest rate
for the cash he/she is taking in through the repo. In other words, “specials”
are often repoed at rates far lower than GC repos – even approaching
0% at times.

3.6.1 Custody of Collateral

A major issue in a repo transaction is who holds the collateral? There
are 3 basic alternatives:
i) Delivery repo: The buyer takes custody of the collateral from the
seller.
ii) Hold – in – custody (HIC) repo: The seller retains custody of the
collateral on behalf of the buyer. This is or can be, for obvious
reasons, very risky. It is the cheapest form of custody, and
therefore the buyer should be rewarded with a higher repo rate
– beware of double dipping! (see:3.8)
iii) Tri – party repo: Collateral is transferred into the custody of the
buyer. The custodian services are, however, performed by an
independent 3rd party. This is usually the method of choice.

3.6.2 Rights of Substitution

Sellers may be reluctant to use certain securities as collateral in
longer – term repos. They may require these assets for some purpose
or other. If however they are being used as collateral then they

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cannot be “touched”. A solution is for the repo seller to seek or

request a “right of substitution” of collateral from the buyer. As the
term implies this allows the seller to substitute existing collateral with
alternative collateral of equivalent value and quality.

Substitution rights are valuable to the seller, but they may be

inconvenient to the buyer. Accordingly, the buyer will seek a higher
repo rate in exchange for granting rights of substitution.

3.7 Haircuts
Remember that the assets sold by the seller (and therefore bought by the
buyer) represent the collateral for the loan. To build protection against
fluctuations in the valuation of these assets, the buyer often insists on a
“haircut” on the assets. This haircut represents a discount on the current
value of the asset, thereby building in some protection against
fluctuations. The level or extent of the haircut can range from 2%, for high
quality credit assets, to 50%, for some volatile emerging market credit risk.
There are 2 methods used to calculate the haircut.

Please bear in mind that whilst both methods are correct, method i) is the
more popular method and must be used in the exam!

i) Preferred method:
Nominal value EUR 10m
Dirty or all-in price 101.256
Haircut 2%

Total market value of the collateral = 100 000 x 101.256

= 10 125 600
Now apply the haircut:
10 125 600
= 9 927 058.82
1.02

ii) Nominal value EUR 10m

Dirty or all-in price 101.256
Haircut 2%

Total market value of the collateral = 100 000 x 101.256

= 10 125 600
Now apply the haircut:
10 125 600 x 98% = EUR 9 923 088

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Please note that there is a slight discrepancy between the 2

amounts. Either method is correct, but to repeat, method 1 is
preferred.

3.7.1 Variation Margin

Haircuts are in essence a form of margin. To maintain the
intended balance between the collateral and the cash in the
repo i.e. the margin, use is made of variation margins. Variation
margins are additional transfers of collateral or cash made
during the term of the repo. The variation margin maintains the
margin between the cash value and the value of the securities
i.e. the haircut. If the value of the collateral falls during the
period of the repo, then the seller will have to “top up” by
providing additional or variation margin. Conversely, if the value
of the collateral increases, then the seller can demand that the
buyer returns the extra collateral. In the case of a buy and sell
back agreement this process i.e. the requiring of more collateral
or the return of some collateral is actioned by terminating the
original agreement and immediately reinstating a new
agreement with the requisite amount of collateral.

Example 11:
From the following information calculate the amount of variation
margin required by the repo buyer from the repo seller if the
market value of the underlying securities has decreased.
Dirty price of securities on commencement: EUR10 358 600
Haircut 2%
Nominal value of underlying securities: EUR 10m
Current market value (dirty price) of underlying securities:
EUR 10 100 000

Answer:
10 358 600
Amount borrowed / lent =
1.02
= EUR 10 155 490.20

Current value of underlying securities = EUR 10 100 000

Therefore minimum amount of variation margin required will be

EUR 10 155 490.20 - EUR 10 100 000 = EUR 55 490.20

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3.8 Day Count and Annual Basis Conventions For

Selected Currencies:

Euroland EUR € Money Market and repo based on ACT/360

Bond Markets (annual coupons except for
Italian government which are based on a semi-
annual basis) based on ACT/ACT
Great Britain GBP £ Money Market and repo based on ACT/365
Bond Markets (semi - annual coupons) based on
ACT/ACT
Japan JPY ¥ Money Market and repo based on ACT/365
Bond Markets (semi annual coupons) based on
ACT/365
Switzerland CHF Money Market and repo based on ACT/360
Bond Markets (annual coupons) based on
30(E)/360
USA USD $ Money Market and repo based on ACT/360
Bond Markets (semi annual coupons) based on
ACT/ACT

3.8.1 Some International Bonds

The following is a list of some of the more popular generic terms
and characteristics of some of the international bonds that may
appear in the exam.

Country Bond Name Day Count Convention

France OATs 1 (Longer term Annual coupons
bonds) ACT/ACT
BTANs (Shorter dated
2

bonds)
Germany Bunds3 Annual coupons
Bobls4 ACT/ACT
Italy CCTs 5 Semi - Annual coupons
CTOs 6 ACT/ACT
UK Gilts Semi Annual coupons
ACT/ACT
United States T Notes (Shorter than 10 Semi Annual coupons
years) ACT/ACT
T Bonds (Longer than
10 years)

1 Obligation Assimilable du Tresor

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2 Bons du Tresor a Taux Fixe et Interet Annuel.

3 Bundesanleihe
4 Bundesobligation
5 Certificato di Credito del Tesoro
6 Buono del Tesoro con Opzione

3.9 Additional Repo Terminology

1. Cash and Carry Arbitrage: When one buys the bond and then
immediately repos it to finance the purchase and then sells it some
time in the future.
2. Cash Driven Trade: According to the Bank of England Code of Best
Practice, where the principal reason for entering into a repo
transaction is to generate cash balances. Typically no haircut or
margin is applied.
3. Cross Currency Repo: Where the cash loan and the collateral are
denominated in different currencies.
4. Dollar Repo: Where the buyer returns, at maturity, different securities to
the original collateral.
5. Double Dipping: When the seller of the repo uses the same collateral in
more than one repo. This is of course illegal. Double dipping can occur
in HIC type repos.
6. Double Indemnity: A classic repo is described as having unique
“double indemnity” status because of counterparty credit
considerations supported by the quality of the issuer of the collateral.
7. Equivalent Securities: The repo buyer must return “equivalent
securities” at maturity. This does not mean that they have to have
exactly the same serial numbers etc.
8. Flat Basis: A repo on which there is no initial margin or haircut.
9. Flex Repo: A repo with a pre-arranged repayment schedule across the
life of the repo.
10. Icing: This is the practice of holding gilts in reserve at the request of
other parties who may require them in repo operations. This is subject
to “open challenge” by other parties who may also want these
securities.
11. Matched Book Trading: The repo trader makes two – way prices for
repo transactions as a market maker. This does not mean that the
dealer has a matched or square position!
12. Rebate: The lending fee in a securities lending transaction is deducted
from the interest paid on cash collateral.
13. Spread Trade: A strategy involving (selling) a repo of a security at a
lower interest rate and then (buying) a (reverse) repo at a higher interest
rate.

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3.10 Worked Examples

Example 12:
Calculate the amount to be repaid at the end of a 7 day GC repo given
the following information:
Security: 5.75% OATs maturing 28/2/20(Annual - Act/Act)
Settlement Date: 31/3/04
Nominal: EUR 50 million
Repo Rate: 4 3/8%
Market Value: EUR 49 633 866
Accrued interest 0.502732
Period: 7 days

Answer:
Step 1:
Calculate the interest on the repo
7
43/8% x EUR 49 633 866.00 x = EUR 42 223.25
360

Step 2: Amount to be repaid

EUR 49 633 866.00 + EUR 42 223.25 = EUR 49 676 089.25

Example 13:
The same details as for example 7 above apply, except that the repo
buyer insists on a haircut of 2%. Calculate the amount to be repaid on
termination date of the repo.

Answer:
Step 1: Market Value of the collateral is EUR 49 633 866.00, but a
haircut of 2% must still be applied.
Therefore: €49 633 866.00 ÷ 1.02 = €48 660 652.94

Step 2: Calculate the interest:

7
43/8% x EUR 48 660 652.94 x = EUR 41 395.35
360

Step 3: Amount to be repaid

EUR 48 660 652.94 + EUR 41 395.35 = EUR 48 702 048.29

Example 14:
You agree to do a 14 day repurchase agreement. 7 days before the
maturity of the agreement the issuer pays a coupon of EUR 1 800 000.

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Calculate the amount to be repaid at the end of the 14 days if you have
been quoted the following:
Security: 6% OATs maturing 31/03/15(Annual - Act/Act)
Settlement Date: 24/03/10
Nominal: EUR 30 million
Repo Rate: 3.5/4.00
Market Value: EUR 32 135 979
Period: 14 days

Step 1: Determine at what rate you are borrowing/lending money:

The important phrases are:
You agree to do a 14 day repurchase agreement, &
You have been quoted
These 2 phrases indicate that you are borrowing money (You agree
to do a 14 day repurchase agreement) and that you are the price
taker (You have been quoted), therefore:
You are borrowing money at a rate of 4%

Step 2: Calculate the amount of interest payable over 14 days:

14
EUR 32 135 979 x 4% x = EUR 49 989 (ignore cents)
360
Therefore amount to be repaid is:
EUR 32 135 979 + EUR 49 989 = EUR 32 185 968

Note: The coupon paid by the issuer (7 days before the maturity of the
agreement) would have been received by the buyer of the repo for
onward delivery to the seller of the repo – this is referred to as a
“manufactured coupon”. Therefore there is no effect on the “outcome”
of the agreement.

Example 15:
Same details as for Example 14, except that instead of doing a repo, a
buy and sell back transaction was concluded.

So what’s the difference?

Referring to the table on page 24, under the heading “Coupon Payment”
you will notice that in a repo, the coupon is returned by the buyer to the
seller. In a buy and sell back agreement however; it (the coupon) is kept
by the buyer!

In this example, a coupon is payable 7 days before the end of the

agreement. In example 14 above, the fact that the coupon was paid

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during the period of the repo was ignored in that it had no effect on the
outcome of the repo transaction. The coupon would have been returned
to the seller (of the repo). However, because this transaction is a buy and
sell back agreement we must certainly take cognizance and make
allowances for this coupon payment!

Steps 1 – 3: Proceed exactly as if it were a classic repo i.e. the amount to

be repaid at the end of the period, if it were a classic repo, would be
EUR 32 185 968

Now take into account the fact that this is not a classic repo but rather a
buy and sell back agreement!

Step 4: 7 days before the agreement was due to terminate the buyer
(lender of cash) would received a coupon amount of EUR 1 800 000.
Under “normal” circumstances this would have gone back to the seller,
but now it is kept by the buyer. Bearing in mind that the payment on
maturity should have been EUR 32 185 968 (see example 14). The buyer
has however already received an amount of EUR 1 800 00 (from the
coupon). The amount owing by the seller should therefore be:
€ EUR 32 185 968 – EUR 1 800 000 = EUR 30 385 968.00

Step 5: The coupon was 7 days earlier than the agreement was due to be
terminated.

The standard rule of thumb for buy and sell back agreements is that any
coupon received during the period of the transaction can be re-invested
(by the buyer) at the same rate (at which the transaction was concluded)
for the remaining period of the agreement!

In other words:
 The transaction was concluded at a rate of 4%, and
 The coupon was received 7 days before the maturity date of the
transaction.
Therefore the coupon can be reinvested at a rate of 4% for a period of
7
7 days – EUR 1 800 000 x 4% x = EUR 1 400. This amount must also be
360
subtracted from the “original” terminal amount!

Step 6: Calculation of 2nd cash flow

EUR 32 185 968 – EUR 1 800 000(coupon amount) – EUR 1 400 (interest on
coupon)
= EUR 30 384 568

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ACI Dealing Certificate: Cash Money Markets

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