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Examine the usual reasons for entering repos, among them cash management and liquidity management.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Repurchase Agreements and Financing · FRM2.LTR.13.b

The idea

Repos serve both sides of the market. A cash-rich party, such as a money market fund or corporate treasurer, uses a reverse repo for cash management. It earns a short-term return while holding high-quality collateral, which is safer than an unsecured deposit. A cash-needy party uses repo for liquidity management: it raises cash against securities it owns, without selling them outright, and so keeps the price exposure and avoids a fire sale. Dealers fund inventory this way, and leveraged investors use repo to finance positions, with the haircut being the equity they must supply. A reverse repo is also the standard route to borrow a particular security to deliver against a short sale. Repo funding is usually cheaper than unsecured funding because it is collateralised, but the haircut still has to be financed elsewhere.

Formulas

Position a leveraged repo investor can carry

Position = Equity ÷ Haircut

Equity
the investor's own funds, used to cover the haircuts
Haircut
the repo haircut, as a fraction of market value

Leverage is one over the haircut, so a small price fall is a large share of equity. Treating the haircut as a multiple of leverage understates the risk.

A practice question

From the question bank, with the reason each wrong option is wrong.

A corporate treasurer has USD 30 million of surplus cash for two weeks and chooses a reverse repo against Treasury collateral rather than an unsecured bank deposit. Which is the best description of this motive?

  1. Cash management: a short-term return on spare cash, protected by collateral. - correct
  2. Liquidity management: raising cash against securities the treasurer already owns without selling them.Why not: Describes the cash borrower's use of repo; the treasurer here is lending cash, not raising it.
  3. Obtaining the collateral's coupons and price appreciation economically for the term of the trade.Why not: Confuses a reverse repo with a total return swap; the collateral's economic exposure stays with the seller.
  4. Taking permanent ownership of the Treasuries to build a long-term bond portfolio.Why not: Ignores the commitment to resell the securities at maturity; the securities are returned.

A reverse repo invests surplus cash short term and is protected by collateral. That is cash management by the cash lender; raising cash against securities is the borrower's liquidity management.

A harder one

A hedge fund has sold short a Treasury note it does not own and must deliver it tomorrow. Which approach is the standard way to obtain the specific note through the repo market?

  1. Do a reverse repo: lend cash, receive the note, and deliver it into the short sale. - correct
  2. Enter a repo in which the fund delivers cash to the counterparty and receives the note when it matures.Why not: Misdescribes the trade; in a repo the cash is received, not delivered, and the fund has no note to repo out.
  3. Enter a repo in which the fund pledges the note as collateral to raise cash.Why not: The fund does not own the note, so it has nothing to pledge; it first needs to obtain the note.
  4. Do nothing, since a short sale in Treasuries has no delivery requirement for the borrowed note.Why not: Ignores that a short seller must deliver the security at settlement and so must borrow it first.

A short seller borrows the security through a reverse repo: cash goes out, the note comes in, and it is delivered into the sale. At the end the short is covered and the note is returned to the lender in exchange for the cash.

The hardest tier

A fund treasurer reviews four activities. Which one is an example of liquidity management by the cash borrower, as opposed to cash management by the cash lender?

  1. An asset manager places daily surplus client cash in overnight reverse repos with Treasury collateral.Why not: Investing surplus cash is the lender's cash management, not raising cash against securities.
  2. A corporate treasury invests a seasonal cash surplus in 3-month term reverse repos to earn more than on bank deposits.Why not: Another example of the lender earning a return on spare cash, i.e. cash management.
  3. A bank sets up repo lines so it can turn its unencumbered securities into cash in a stress. - correct
  4. A money market fund uses reverse repos to keep its cash invested overnight with collateral protection.Why not: The fund is lending cash and holding collateral, which is the cash management motive.

Liquidity management is about being able to raise cash against securities when needed, as the borrower. The other three place surplus cash for a return while holding collateral, which is cash management.

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