Money-market instruments and repurchase agreements

Short-term paper, and a sale that is really a loan

Short-term corporate borrowing, such as commercial paper, sits with T-bills and negotiable CDs in the money market.

The money market is where short-term, high-quality debt trades, and three of its instruments come up by name. Commercial paper is a short-term, unsecured promissory note issued mainly by corporations. It is usually sold at a discount and pays face value at maturity, so the discount is the holder’s return. Maturities run up to 270 days and average about 30, and commercial paper is exempt from SEC registration if its maturity does not exceed 270 days. A banker’s acceptance is a draft that a bank has accepted: the accepting bank takes an unconditional obligation to pay the face amount to whoever holds the draft on the date stated in it. The accepted draft is sold at a discount, and it is negotiable, so it can be resold before it matures. A certificate of deposit holds a fixed amount of money at a bank for a fixed period, such as six months, one year or five years, and the bank pays interest in exchange. Its terms should state the maturity date and any penalty for withdrawing the money early. CDs bought through a brokerage firm are brokered CDs; they can generally be sold before maturity in a secondary market, but that market may not always exist and the sale price can be below what was invested.

A certificate of deposit is a bank deposit, and that sets it apart from the rest of this list. At an FDIC-insured bank, standard deposit insurance covers $250,000 per depositor, per insured bank, per ownership category. Deposit insurance does not cover securities such as stocks, bonds or mutual funds, and commercial paper is the issuing company’s own unsecured note, not a deposit. A Treasury bill, by contrast, carries the full faith and credit of the United States.

One money-market arrangement is worth separating out because it is not what it looks like. In a repurchase agreement — a repo — one firm sells a security to another and promises at the same moment to buy it back at a later date, often the next day, at a specified higher price. Nothing about that is really a disposal. The economic effect is a short-term loan secured by the security: the cash goes one way, the security goes the other as collateral, and the difference between the sale price and the repurchase price is the interest on the loan. In a bilaterally settled repo the first leg is a sale: the buyer takes title to the specific security and may sell or rehypothecate it. Because the repurchase is agreed at the outset, the economic effect is that of a loan secured by the security.

Two details follow from that, and both are tested. The cash lender normally takes collateral worth more than the cash it advances — overcollateralization — so that if the collateral falls in value and the counterparty then fails to repurchase, the lender can still recover principal and interest. And the name depends on which side of the table you are sitting: the same transaction is a repurchase agreement to the party selling and borrowing, and a reverse repurchase agreement to the party buying and lending. A question that asks whether something is a repo or a reverse repo is really asking whose point of view you have been given.

Exam terms

Commercial paper

Short-term unsecured corporate promissory note, usually sold at a discount, maturing in up to 270 days.

Banker’s acceptance

A draft accepted by a bank, which must pay the holder its face amount on a stated date; sold at a discount and negotiable.

Certificate of deposit

A bank deposit of a fixed amount for a fixed term, paying interest, usually with an early-withdrawal penalty.

Repurchase agreement

A sale of a security with an agreement to buy it back at a set price on a later date; in economic effect, a short-term secured loan.

Reverse repurchase agreement

The same transaction seen from the side that buys the security and lends the cash.

Worked example

A dealer needs cash overnight. It sells Treasury notes worth $10 million to a money-market fund for $9,900,000 in cash and agrees, at the same moment, to buy them back the next day for $9,900,550.

1. On paper the dealer has sold the notes, but the buy-back is agreed at the outset and at a set price, so the economic effect is a one-night loan secured by the notes.
2. The dealer is raising cash, so to the dealer this is a repurchase agreement. The fund is buying the notes and lending cash, so to the fund it is a reverse repurchase agreement.
3. The interest is the price gap: $9,900,550 − $9,900,000 = $550 for the night.
4. The fund advanced $9,900,000 against notes worth $10 million. The extra $100,000 of collateral protects it if the notes fall in value and the dealer then fails to buy them back.
5. None of that extra collateral is paid to the fund. When the dealer repurchases, the fund returns the notes and keeps only the agreed price difference.

Check yourself

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Related practice

• Repurchase agreementsPractice this
• Debt security denominations and trading featuresPractice this
• Issuer type and repayment sourcePractice this