Illustrative Example of A Repurchase Transaction

A few weeks ago, we introduced the topic of repurchase agreements (repos). Today, we will present a worked-out example of a repo transaction so as to better illustrate its most important concepts. In this example, Prime Broker B finances repo positions for Hedge Fund H. Two broker/dealers, Broker M and Broker S, also participate as counterparties in this example.

Repos provide leverage: Hedge Fund H gets the use of a security without having to expend the purchase price of the security. Instead, Hedge Fund H is charged repo interest on the cash borrowed from Prime Broker B, which is offset by the coupon interest Hedge Fund H earns on the security; the difference is the carry on the trade (cost of keeping the position on). Thus, Hedge Fund H is able to finance many more securities this way as compared to outright purchase.

First Monday

On Monday, Hedge Fund H purchases $1M face of 10-year Treasury note with a 6% coupon at a price of 101 from Broker M in the cash market. There is $20,000 accrued interest in the note as of Tuesday, for which Hedge Fund H must pay. The settle date for the purchase is Tuesday (i.e. it is regular settle; cash settle would occur on Monday). On Tuesday, Broker M delivers the Treasury Notes to Hedge Fund H’s custodian, Prime Broker B, and Hedge Fund H wires $1,030,000 ($1M face * 1.01 + 20,000) to Broker M.

First Tuesday

On Tuesday, Hedge Fund H also enters into a 1-week term repo transaction with Broker S for $1M of the same Treasury Note, which is now priced (on Tuesday) at 101.5. The repo interest rate on collateral is 5%. The full price of the note (that is, including accrued interest) is 103.5. Broker S charges a 2% haircut on the Treasury note. Hedge Fund H delivers the $1M par of Treasury notes to Broker S on Tuesday. Broker S pays Hedge Fund H ($1,035,000 full price / 1.02% haircut) = $1,014,706 proceeds. (In reality, the price is usually rounded. In this case, it would probably be rounded to $1,015,000).

Note that Hedge Fund H paid out $1,030,000 for the purchase of the security, and received in $1,014,706 by repo’ing the security. Thus, Hedge Fund H’s net cash flow is -$15,294 on the first Tuesday. This reflects both the haircut and the price movement of the security.

Second Tuesday

For the one week period (Tuesday to Tuesday), Hedge Fund H accrued 7 days of coupon interest at 6% annual on $1M = (7/182) * ($1M) * (.03) = $1,153. The note is currently carrying $20,000 + $1,153 = $21,153 accrued interest.

The current price of the Treasury note has risen to 103 over the last week. Hedge Fund H sells the Treasury note to a counterparty for $1,030,000 + $21,153 = $1,051,154.

On the same day, Hedge Fund H receives its $1M par Treasury Notes back from Broker S. No coupon was paid during the period. Hedge Fund H calculates the repo fee to Broker S as 5% on the $1,014,706 proceeds for 7 days = (7/360) * ($1,014,706) * (.05) = $986. This repo fee plus the original proceeds of $1,014,706 sums to $1,015,692, which is the amount Hedge Fund H wires to Broker S.

Note that Hedge Fund H paid out $1,015,692 when terminating the repo, and received $1,051,154 for selling the note, giving Hedge Fund H a positive cash flow of $35,462 on the second Tuesday. When this cash flow is netted against the cash flow from the previous Tuesday of -$15,294, the total profit from the transaction is calculated to be $20,167.

The gain or loss on the buy and sell of securities, calculated on a FIFO-lot basis, plus the interest income earned, less the interest expense incurred, represents the total profit from security trading. Repos and reverse repos are simply methods to finance security trades.

Demand and Supply of Capital for Investments

Demand for Capital

The demand schedule for capital refers to the arrangement of the various proposed projects in a descending order according to their estimated rates of return together with required amounts of capital needed by the respective projects.

Before analyzing the investments, the management must understand the nature of opportunities. Some investments are complimentary i.e. making one investment implies that another investment will be necessary. Some investments are mutually exclusive i.e. acceptance of one, implies rejection of others and some investments are independent. It is therefore necessary to identify the various opportunities of investments. Alternative investments can be ranked according to their relative profitability. It is also important to distinguish between cost reducing investment and revenue increasing investment.

According to W.W. Haynes “any investment decision is profitable if it adds more to revenue than to cost or if it reduces cost more than the revenue.”

An important element in the analysis of demand for capital is the productivity of proposed capital outlay. The yield must be calculated in terms of individual projects. It is the expected productivity of marginal unit of capital i.e. the key factor in the appraisal of allocating capital funds and not the profitability of the old and sunk investment based on the estimates of the historical costs. The past is useful only as a guide to the future i.e. the future profit which is more relevant and influences demand for capital; besides the capital yield should be calculated over the whole lifetime of the asset. Undoubtedly all the future ventures of capital investment involve risks.

 

Supply of Capital

There are fundamentally two sources of supply of capital:

1. The internal sources of supply of capital are depreciation charges, and retained earnings. The capital expenditure of many firms is confined purely to the amount that can be secured internally. Therefore amount that can be expected from accumulated depreciation and from retained earnings comprises the most significant part of capital budgeting. The retained earnings as a source of supply of capital makes the plough back policy an integral part of capital budgeting.
2. The external sources of capital are issue of shares and debentures and inter- firm borrowings. The external sources which depend on issue of shares, debentures and inter firm borrowings are very volatile and depend upon the overall atmosphere in the capital market, the company’s reputation, its financial backing and the integrity of its management. Whenever the firm decides to acquire external source of finance its project, it has to think many a times about the cost of capital.

 

Cost of Capital

The cost of capital is the rate which must be paid to obtain funds for operating the enterprise. As the supply of capital comes from several sources, each source has to be analyzed carefully because every source has a different cost component.

There are innumerable difficulties that arise while measuring the cost of capital and hence the determination of company’s cost of capital is subject to various margins of error. The computed values can be at the most regarded as fair approximations of the cost. The cost approximation includes the computation of the cost of debt capital, as well as cost of preference share capital, the cost of equity capital, the cost of retained earnings, the cost of depreciation funds etc. The capital costs are determined by a number of forces that exert their influence on capital markets. The Government itself is the single most important determinant of the interest rate structure through resorting to various policy measures by exercising control over reserve requirements, rediscounting facilities selective controls and open market operations. The Government influences the cost of capital. Similarly the investor’s psychology, their confidence and business outlook also affect the yields on security issues. Estimating the cost of capital requires the knowledge of market value of securities and cost of floatation.

To conclude, the cost of capital is a complex subject although determining the firm’s cost of capital is an essential part of capital budgeting process. Firms raise funds in many forms including long-term and short-terms debts, stock, retained earnings and lease financing. Each source of funds has a cost and these costs are the basic inputs in the cost of capital determination.