5.2.5Repurchase agreements

A repurchase agreement is an agreement to buy any securities from a seller on the

understanding that they will be repurchased at some specied price and time in the

future. However, since the length of any repurchase agreement (or ‘repo’) is likely to

be short, a matter of months at most, it is customary to think of repos as a form of

short-term nance and therefore, logically, as being an alternative to other money

market transactions. In section 5.3 we shall note that the Bank of England now

conducts ‘gilt repos’ as a means of inuencing money market interest rates. ‘Gilts’

are government bonds, with long initial maturities (and thus we discuss them in

the next chapter), but the Bank of England seeks to inuence money market rates

by conducting short-term repos in gilts of any residual maturity (provided that it

exceeds the term of the repo). Since the effect of the repo deal falls upon money

market prices and yields, it is normal to regard such repos as money market deals.

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Chapter 5 • The money markets

In a repo, the seller is the equivalent of the borrower and the buyer is the lender.

The repurchase price is higher than the initial sale price, and the difference in price

constitutes the return to the lender. Deals are quoted on a yield basis, using eqn 5.2.

Thus if the Bank of England agrees to a gilt repurchase deal with a commercial bank,

it may buy the bonds for £1m, agreeing to resell in fourteen days for £1.002m. If so,

the yield can be found as follows:

i(1.002 1.0) (1.0 0.038) 5.26%

In this example, the sale price of £1m is likely to be slightly less than the market

value of the bonds at the time of purchase. This margin offers some protection to

the lender in case the borrower goes bankrupt or defaults for some other reason.

The size of the risk, and thus this margin, depends in large part upon the status of

the borrower, but it also depends upon the precise nature of the contract. Some

repo deals are genuine sales. In these circumstances, the lender owns the securities

and can sell them in the case of default. In some repo contracts, however, what is

created is more strictly a collateralised loan with securities acting as collateral while

remaining in the legal ownership of the borrower. In the case of default, the lender

has only a general claim on the lender and so the margin is likely to be greater.

5.2.6The euromarkets

So far, we have discussed a variety of money market instruments which enable

short-term lending and borrowing to take place in the domestic currency – that is,

the currency of the country in which the markets are located. However, in recent

years some of the fastest growing markets have been the so-called ‘eurocurrency’

markets. These are markets in which the borrowing and lending that takes place

is denominated in a currency of some other country. Generally speaking, the

instruments available for this type of transaction are the same as those which we

have just discussed. However, where such instruments are denominated in some

other currency, they are identied by the prex ‘euro-’, though this is clearly a mis-

nomer since the currency can be anycurrency (US or Hong Kong dollars, or yen, for

example) and the trading can be taking place anywhere (in New York or Tokyo or

Hong Kong), not just in Europe. A eurocurrency instrument is in fact anyinstrument

denominated in a currency which differs from that of the country in which it is traded.

Thus it follows that ‘euro-’ instruments can be found all over the world and have

no obvious connection whatever with Europe. The ‘euro-’ prex is just a reminder

that the practice of trading instruments denominated in foreign currencies began

with the US$ being traded in Europe. Since dollar deposits rst began to be held in

European banks in the late 1960s, the eurocurrency markets have grown rapidly, the

stock of eurocurrency assets being estimated by 1995 at over $6,000bn. In the 1980s

alone they expanded over threefold. The eurocurrencymarkets predate the markets

for eurobonds(which we discuss in Chapter 10). Why did eurocurrency markets develop

and what, if any, is their signicance?

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