Charta is on Google Play: practise on the go. Get the app
Charta

Recognise the traits of special spreads and trace how a US Treasury issue's special spread tends to evolve from one auction to the next.

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

The idea

The special spread of an issue is the GC repo rate minus the repo rate on that specific issue, usually quoted in basis points. It is zero or positive, because the owner could always repo the bond at GC. Specialness comes from demand to borrow a particular bond, mainly to cover short positions and hedges, relative to the supply available. In US Treasuries it follows the auction cycle. The most recently auctioned issue of a maturity, the on-the-run issue, is the one that tends to trade special. The spread emerges around the auction and generally remains while the issue is on the run. When the next issue of that maturity is auctioned, demand moves to the new issue and the old one's special spread falls sharply. The exam point is that specialness is temporary and tied to on-the-run status.

Formulas

Special spread of an issue

Special spread = GC − Special

GC
the general collateral repo rate
Special
the repo rate on the specific issue

Zero or positive and quoted in basis points; reversing the order gives a negative number. It is widest for the on-the-run issue and falls sharply at the next auction.

A practice question

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

The special spread of a security is defined as:

  1. the GC repo rate minus the repo rate on that specific security. - correct
  2. the repo rate on that specific security minus the GC repo rate.Why not: Reverses the sign; the spread is quoted as a non-negative number below GC.
  3. the yield on the security minus the GC repo rate.Why not: Uses the bond's yield, which is not part of the definition.
  4. the on-the-run yield minus the off-the-run yield of the same maturity.Why not: Defines the on-the-run premium, not a repo rate spread.

Special spread = GC rate - special repo rate. It is positive for a security that is in demand to borrow, and it measures how much cheaper the cash is for the owner.

A harder one

The current on-the-run 10-year Treasury note is trading with a special spread of 60 basis points. The Treasury now auctions a new 10-year note. The special spread of the previous 10-year note is most likely to:

  1. rise sharply, as the old note is now scarcer.Why not: Wrong: scarcity of a bond does not make it special unless demand to borrow it is high; demand moves to the new note.
  2. fall sharply, as borrowing demand shifts to the new note. - correct
  3. remain unchanged, since the old note is still a 10-year security.Why not: Ignores that on-the-run status drives specialness.
  4. turn negative, since the old note is now excluded from repo.Why not: Special spreads do not turn into penalties; the old note simply trades near GC.

Once the next issue of a maturity is auctioned, hedgers and shorts switch to it, and the previous issue becomes off-the-run. Its special spread typically declines sharply.

The hardest tier

A trader owns the current on-the-run 5-year note, auctioned three weeks ago, which trades with a large special spread. The next 5-year auction is in one week. Which is the best view on how to value the financing advantage?

  1. Treat the spread as permanent and capitalise it over the life of the bond.Why not: Specialness is temporary and linked to on-the-run status.
  2. Expect the spread to rise after the next auction because the old note will be scarcer.Why not: Opposite of the pattern: demand to borrow moves to the new issue.
  3. Count it only until the next auction, after which the spread should fall sharply. - correct
  4. Ignore the spread, since repo financing only reflects the creditworthiness of the borrower.Why not: Ignores the collateral-specific demand that makes the security special.

Specialness lasts while the issue is on-the-run. After the next auction, the spread collapses, so any value assigned to cheap financing should cover only the remaining on-the-run period.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Repurchase Agreements and Financing