How financing works

Financing products fund a position or lend against one. This page explains what each one is for, why the bond products all read a repo curve, why a repo is held to a margin, and what a lender is really paid for on a loan. The calls themselves are on the reference pages this page links.

The repo curve

Holding a bond costs whatever it costs to borrow the cash that bought it. The cheapest way to borrow that cash is to lend the bond itself as collateral, in a repo. So the rate that prices a bond held over time, whether delivered later, swapped for its return, or lent out, is a repo rate, not an unsecured one.

Most repo trades against general collateral (GC): any bond from an agreed basket, at a rate a little below the overnight unsecured rate. A bond in heavy demand trades special, at a lower rate, because lenders of cash will accept less to get that particular bond. helixio holds the GC curve as a spread over the currency's overnight discount curve, and a special as a further spread over GC, so one quote moves the whole financing curve consistently. The curves are on repo spread curves.

Repo

A repo sells a bond for cash today and buys it back on a later date for the cash plus interest. The seller has borrowed cash against the bond; the other side, in a reverse repo, has lent cash and holds the bond meanwhile. Dealers use repo to finance their bond inventory, and money funds use reverse repo to lend cash safely.

If the bond pays a coupon during the term, someone has to get it. In a classic repo the buyer passes it straight back to the seller, who still owns the bond's economics. In a buy/sell-back the buyer keeps it, and the repurchase price is lowered to match. The two trades move the same economics by different routes, so their cash legs differ by about a coupon while the packages, each with its bond, differ far less. The calls are on repo.

Haircuts and margin

A lender of cash wants more collateral than the cash it lends, so a fall in the bond's price doesn't leave it short. A margin ratio of 1.02 (102% margin) lends the collateral's value divided by 1.02. The same protection is often quoted as a haircut, the share of the collateral's value that isn't lent: one minus one over 1.02, which is 1.96%, not 2%. The two quotes describe one trade.

During the term the collateral is revalued. If it's worth less than the margin ratio times the cash exposure, the borrower owes the difference: a margin call. If it's worth more, the excess can come back. The steps are in value a repo and its haircut.

Bond forwards and carry

Buying a bond for delivery later is the same as buying it now and financing it until then: you pay the spot price, earn the coupons paid before delivery, and pay the repo interest. So the fair forward price is the spot price carried forward on the repo curve, less the coupons the buyer won't receive.

The difference between what the bond earns and what its financing costs is its carry. When the coupon earns more than the repo rate costs, the carry is positive and the forward clean price sits below the spot clean price. A forward struck at the fair price is worth nothing; struck a point higher, it costs the buyer about a point on the face, discounted from delivery. The calls are on bond forward.

Total return

A total return swap passes a bond's whole return, its coupons and its price change, to one side, in exchange for funding on the cash the bond would cost. The receiver gets the economics of owning the bond without buying it; the payer, often a dealer that holds the bond, has financed it synthetically.

The swap resets on a schedule: each period settles the price change and starts again from the new price. That has a consequence on a later valuation date. A reset that has already happened set a price the market doesn't hold, so the swap has to be restated from that reset, at the price struck then, before it can be valued. And if the restated swap's first funding period has begun on a floating rate with no index to read, its rate can't be known; funded at a fixed margin, it can. The calls are on bond TRS.

Loans

A term loan is the simplest credit instrument a bank holds. The lender pays the principal out, receives interest each period, and gets the principal back at the end, or in instalments if the loan amortises. The interest is fixed, or floats on an index plus a margin, which is what the loan market quotes.

What the lender is really paid for is the borrower's credit. Against the borrower's survival curve, the interest and repayments are at risk, and on default the lender recovers only a share of what's still outstanding. The drawdown isn't at risk, because the lender pays it. So a loan tagged to its borrower is worth less to the lender than the same flows discounted risk-free, and its fair rate is higher.

Most loans also let the borrower prepay, usually at par. The borrower will prepay when rates fall, which is when the loan is most valuable to the lender, so the right costs the lender. A puttable deposit gives the lender the mirror right, to demand repayment, which adds to its value. Both are options on future rates, so they're valued on a rate model's lattice, as a callable bond is. The calls are on loan.

Fees

A fee is one known amount on a date: an arrangement fee on a loan, an upfront on a swap, a break cost. It has no rate and no index, so its only market input is the discount factor to its payment date. Desks book fees beside the trade they belong to, rather than folding them into a price, so a book's value carries them and their cashflows show up where they're paid. The call is on fee.