What Is the Implied Repo Rate?
The implied repo rate is the rate of return that can be earned by simultaneously selling a bond futures or forward contractand then buying that actual bond of equal amount in the cash market using borrowed money. The bond is held until it is delivered into the futures or forward contract and the loan is repaid.
Key Takeaways
- An implied repo rate is the rate of return that can be earned by owning a bond and simultaneously shorting a futures or forward contract against it.
- This strategy functions much like a repurchase agreement (repo), in that the bond that the bond that is owned will be taken back when the short futures contract expires.
- This net return, or repo rate, tends to be close to the risk-free rate as the buying and selling involved amount to arbitrage.
Implied Repo Rates Explained
The repo rate refers to the amount earned, calculated as net profit, from the processing of selling a bond futures contract, or other issue, and subsequently using the borrowed funds to buy a bond of the same value with delivery taking place on the associated settlement date. The implied repo rate comes from the reverse repo market, which has similar gain/loss variables as the implied repo rate, and provides a function similar to that of a traditional interest rate.
Understanding Repos
A repo refers to the repurchase agreements that, by arranging to buy and subsequently sell a particular security at a specified time for a predetermined amount, function as a form of a collateralized loan. Generally, a dealer borrows an amount of funds less than a particular bond’s value from a customer and the bond functions as collateral. Since the amount borrowed is less than the value of the bond, the lending customer has a reduced level of risk if the value of the bond decreases before the repayment time is reached.
Settlement Date
Terms regarding when repayment of the loan is required, referred to as the settlement datecan vary. In many instances, the funds are only held by the borrower overnight, causing the transaction to complete within a business day. Longer terms can be made available, though the majority remain under 14 days in length.
In transactions between money market funds and hedge funds, a bank may participate as a form of middleman. This allows the money market funds, which are supported by cash, and hedge funds, which are traditionally supported by bonds, to smoothly move funds between entities.
The market upon which these transactions take place is referred to as the repo market. After the financial crisis of 2008, the size of the repo market saw a reduction of approximately 49%, spurred by the bank industry’s reluctance to lend Treasuries. This, in turn, made it more challenging for investors in the repo market to find interested borrowers looking for cash.
Applications Outside of the Bond Market
All types of futures and forward contracts have an implied repo rate, not just bond contracts. For example, the price at which wheat can be simultaneously purchased in the cash market and sold in the futures market, minus storage, delivery and borrowing costs, is an implied repo rate. In the mortgage-backed securities TBA market, the implied repo rate is known as the dollar roll arbitrage.