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How Repo Rates Determine a Bond’s Financing Cost

Article Quant Q&A · Author: Peaceful
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Summary

The note explains why repo is treated as the financing cost of a bond, even though a cash lender in a repo receives both interest and bond collateral. It clarifies the usual trading terminology: bidding repo means seeking the bonds, while offering repo means owning bonds and lending them for cash. A repo can also be understood as an agreed purchase followed by a later resale.

The bond seller accounts for the coupon lost during the transaction through the agreed prices, while the cash borrowed incurs interest reflected in those prices at the repo rate. The note uses a buy, repo, and later buyback sequence to illustrate that the financing mechanics alone should not create an expected profit. The investor retains exposure to bond price movements, however, so the final market sale price can produce a gain or loss. The explanation is conceptual and does not quantify specific repo conventions, collateral terms, or risks such as haircuts and counterparty default.

Key ideas

  • Repo pricing incorporates cash interest at the repo rate, which is why repo is described as a bond’s financing cost.
  • The bond seller’s agreed prices account for coupon economics over the repo period.
  • Offering repo generally means lending owned bonds against cash; bidding repo means seeking collateral.
  • A repo does not eliminate the bond’s price exposure, so market movements can still cause gains or losses.

Tags

Fixed incomeCarryArbitrageMarket microstructure
Full text
# why the financing cost of a bond is repo?


# why the financing cost of a bond is repo?












In a repo transaction, the cash borrower pays an interest in repo rate for borrowing the cash. On the other hand, the cash lender gets a bond as collateral. In this transaction, it looks like the cash lender gets a bond as well as an interest payment. He ends up in a long position in a bond without any financing cost (instead with a repo interest as income). this seems to be contradict to what people say “financing cost for bond is repo rate” . can someone please explain to me where my confusion comes from please ?

## Answer by Attack68 (score 2, accepted)

https://quant.stackexchange.com/a/40544

In repo terminology the bid (buyside) is for the collateral, i.e. if one bids repo then one bids for the bonds. And if one offers repo, one owns the bonds and wants to lend the collateral for cash. (Note your question was phrased the other way around in terms of cash and I am trying to lean you toward more regularly used trading terminology.)

This resource [ https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/ ], is very good for answering generic questions on repo.

Semantically, across different jurisdictions, a repo transaction is just a committed buy and sell-back deal. One commits to a buy price on a certain date and simultaneously commits to sell the bonds back on a future date.

How are the buy and sell back prices determined?

The seller of bonds (repo offer) recognises that she loses the right to the bond coupon for the intermittent period, so she adjusts (in her favour) the buy and sellback prices to recover this lost coupon interest - effectively she mechanically maintains financial benefit of the coupon. But she recognises that she has been loaned cash for the period and owes interest on it so adjusts (adversely to her) the buy and sellback prices to include cash interest payment. You will observe that this negative adjustment is calculated from the repo rate, so the true financing cost is the same as the repo rate.

Hopefully you will observe that you should not be able to arbitrage any profit under this scheme. If you buy bonds in the market, sell them on repo to acquire cash for the purchase then buy them back later under the repo and sell them in the market to release cash, you are back where you started and should not have made an expected profit or a loss. However, the final sale price in this scenario is key and subject to market movement, and therefore even if you sell bonds on repo you maintain the financial exposure, or delta risk, to those bonds.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.