Forward starting repurchase agreements (repos) are a type of financial transaction that is commonly used in the securities industry. These agreements are used to manage risks associated with fixed income securities, such as government bonds or corporate debt. In this article, we will discuss the basics of forward starting repos, including how they work and why they are used.
What are Forward Starting Repurchase Agreements?
Forward starting repos are agreements between two parties in which one party agrees to sell an asset, such as a bond, to the other party at a specified price and date in the future, and then buy it back at a higher price at a later date. These agreements are similar to traditional repos, but with a delayed start date.
In a traditional repo, the seller immediately buys back the asset on the same day or a few days later. However, in a forward starting repo, the purchase and sale date is agreed upon in advance, with the start date taking place several days, weeks, or even months later. The seller will typically agree to pay a financing rate to the buyer for the period between the sale and repurchase date, which compensates the buyer for the use of their funds.
How do Forward Starting Repurchase Agreements Work?
Forward starting repos are typically used by fixed income traders and portfolio managers to manage their exposure to market risks and optimize their investment strategies. For example, imagine a portfolio manager who wants to purchase a bond in three months but is worried about the risk of rising interest rates during that time. The portfolio manager could enter into a forward starting repo with a counterparty to lock in the price of the bond today, while delaying the purchase until three months later.
By entering into a forward starting repo, the portfolio manager can effectively hedge their risks and ensure that they will be able to purchase the bond at a predetermined price, regardless of how market conditions change in the interim period. Additionally, the financing rate paid to the buyer of the bond will be locked in, providing certainty and predictability for the portfolio manager`s cash flows.
Why are Forward Starting Repurchase Agreements Used?
Forward starting repos offer several benefits to market participants, including:
Risk Management: By locking in the price of a security and financing rate for a future date, market participants can effectively manage their exposure to market risks, such as changes in interest rates or credit spreads.
Predictable Cash Flows: For fixed income portfolio managers, forward starting repos can provide certainty around future cash flows, as they know the exact amount of cash they will need to have on hand to purchase the security at a certain date.
Improved Liquidity: Forward starting repos can improve liquidity in the market by providing an additional avenue for market participants to buy and sell securities.
Overall, forward starting repurchase agreements are an important financial tool for managing risk and optimizing investment strategies in the fixed income markets. By locking in the price and financing rate of securities for a future date, market participants can hedge against market risks and improve predictability of future cash flows. While forward starting repos may seem complex at first, they are a useful tool for sophisticated investors and traders who seek to optimize their investment strategies.