Question

4. Suppose a dealer bank is considering buying $8,000,000 of bonds and it wants to borrow as much as possible using an overnight repurchase agreement (“repo”).

Suppose the Haircut (HC) on the bonds is currently 0.01 (1%). By pledging the $8,000,000 of bonds as collateral how much could the dealer bank borrow? How much of its own cash would the dealer bank have to contribute to buy the bonds?

Briefly explain how the dealer bank can “rollover” (ie renew) the overnight repo agreement and finance the bonds using borrowed money for a year. Why might this be a profitable action for the dealer bank?

Suppose the repo agreement has been renewed for many days. Now suppose the bond market has become more volatile and the lender of cash is somewhat concerned about the future solvency of the dealer bank. As a result she now demands a 0.03 (3%) haircut (HC) on the bonds in order to renew the repo agreement the next day.

How much cash will the lender now be willing to lend to the dealer bank beginning the next day when accepting the entire $8,000,000 of bonds as collateral?

Assuming the dealer bank does not sell any of the bonds, how much of its own money must it now have to contribute to continue using overnight repo borrowing to finance the entire $8,000.000 amount of bonds? Briefly explain.

Answer 1