Issuance trading and funding - Repos and money market instruments

Learning Outcomes

This article explains how repurchase agreements (repos) and core money market instruments are structured, traded, and used in short-term funding and liquidity management, including:

• Identifying the main types of money market instruments (Treasury bills, commercial paper, certificates of deposit, bankers’ acceptances) and describing their key features, typical issuers, and investors.
• Describing the mechanics of a repo transaction, including the initial sale, the repurchase leg, the role of collateral, and how the repo rate is determined.
• Distinguishing repo financing from unsecured money market borrowing and lending, and relating repos to reverse repos from the viewpoint of each counterparty.
• Analyzing the economic motivations for using repos and money market instruments, such as liquidity management, use of borrowed funds, collateralized borrowing, and low-risk cash investment.
• Evaluating the principal risks in repo and money market positions—counterparty, collateral, liquidity, legal, and operational risks—and explaining how haircuts, margining, and daily marking-to-market mitigate these risks.
• Applying repo and money market concepts to numerical examples, including calculating repo interest, cash flows at maturity, and quoted yields on discount and add‑on instruments.
• Comparing yield quotations on different money market instruments (discount rate, add-on rate, bond-equivalent yield) and converting between them when necessary.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the roles and features of repos and key money market instruments, as well as their use in funding and trading activities, with a focus on the following syllabus points:

• Describing the structure and use of repurchase agreements (repos).
• Explaining the principal types and economic rationale behind common money market instruments.
• Distinguishing between repo funding and other short-term unsecured lending or deposit arrangements.
• Explaining and comparing money market yield quotation conventions (discount basis, add-on basis, bond-equivalent yields).
• Identifying key risks related to money market instruments and repo transactions (e.g., counterparty, liquidity, collateral risks).

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision.

1. In a standard repurchase agreement, which sequence best describes the two legs of the transaction from the standpoint of the securities dealer needing cash?

   • a) Buy the security for cash today and sell it back later at a lower price.
   • b) Sell the security for cash today and repurchase it later at a higher price.
   • c) Lend cash today and receive the security as collateral at maturity.
   • d) Borrow cash today and issue commercial paper to the lender at maturity.

2. Which combination best describes credit-related risks faced by the cash lender in a repo?

   • a) Interest rate risk and reinvestment risk.
   • b) Counterparty default risk and collateral value declining below the exposure.
   • c) Foreign exchange risk and inflation risk.
   • d) Liquidity risk and prepayment risk.

3. What is the primary economic purpose of money market instruments in financial markets?

   • a) Providing long-term capital for corporate expansion.
   • b) Enabling speculative trading in derivatives.
   • c) Providing a mechanism for short-term funding and low‑risk, liquid investment.
   • d) Allowing companies to avoid central bank regulation.

4. In a repo, legal title to the collateral typically:

   • a) Never transfers; the seller always retains legal ownership of the securities.
   • b) Transfers to the cash lender during the repo term, then back at repurchase.
   • c) Transfers to the central bank, which guarantees the trade.
   • d) Remains jointly owned by both parties until maturity.

Introduction

Short-term funding and liquid investment needs are central not only to financial institutions but also to many corporations and governments. Money market instruments and repurchase agreements (repos) are key tools for meeting these needs efficiently. This article reviews the structure and uses of these instruments, focusing on their economic rationale, pricing conventions, and practical risks relevant to CFA Level 1.

Key Term: money market instruments
Short-term debt securities (typically with original maturities of less than one year) used by governments, financial institutions, and corporations to obtain or invest short-term funds. Key Term: repurchase agreement (repo)
A contractual arrangement in which one party sells a security and simultaneously agrees to repurchase it at a specified price and future date. Economically, it is a collateralized loan, with the security serving as collateral.

Repos connect investors who have excess cash with institutions that hold securities but need funding. Money market instruments allow issuers to raise short-term funds directly from investors, and allow investors to hold relatively safe, liquid assets that can be used as cash substitutes.

These markets are closely linked to central bank operations and policy interest rates. Very short-term rates in the money market are often used as benchmarks for valuing other assets and for discounting future cash flows.

Test Tip: When revising Repos and money market instruments, connect each definition, method, or rule to the kind of question the assessment is likely to ask.

The Role of Money Market Instruments

Money market instruments provide issuers with access to short-term funds and investors with highly liquid and relatively safe assets. Their short maturities mean:

• Low price sensitivity to interest rate changes.
• Frequent opportunities for issuers and investors to roll over positions at current rates.
• Lower credit risk than long-term unsecured borrowing (especially for high-quality issuers).

Key types of money market instruments include:

Key Term: Treasury bill (T-bill)
A short-term government security issued at a discount to face value, with no coupons and typical maturities up to one year. Key Term: commercial paper
Unsecured, short-term promissory notes issued by corporations or financial institutions, usually with maturities up to 270 days (often much shorter). Key Term: certificate of deposit (CD)
A time deposit with a bank that specifies an interest rate and maturity date; large, negotiable CDs are actively traded in money markets. Key Term: bankers’ acceptance
A time draft used to finance international trade, where a bank “accepts” the obligation to pay a specified amount at a future date, making the instrument bank‑credit‑worthy.

Treasury bills

• Issued by national governments (e.g., US Treasury, UK Debt Management Office).
• Sold at auction, typically at a discount to par (e.g., price 98 for face value 100).
• Investor return equals the difference between par value received at maturity and the purchase price.
• Considered to have minimal default risk (in domestic currency) and very high liquidity.
• Commonly quoted on a discount rate basis (discussed later).

Commercial paper

• Issued by:

  • Large corporations for working capital needs.
  • Financial companies and banks for balance sheet funding.

• Usually unsecured; credit risk depends on the issuer’s credit rating.

• Maturities typically range from overnight to a few months; in some jurisdictions limited to 270 days to avoid registration as a public security.

• Sold at a discount or sometimes on an add-on interest basis.

• Purchased mainly by money market funds, banks, and large institutional investors.

• Sometimes asset-backed (secured by receivables) to improve credit quality.

Certificates of deposit (CDs)

• Issued by banks to raise term deposits with fixed maturity.
• Retail CDs are generally non‑negotiable and held to maturity.
• Large negotiable CDs can be bought and sold in secondary markets.
• Often quoted on an add-on rate basis (stated annual interest rate applied to principal over the term).
• Credit risk depends on the issuing bank; some may be insured up to a limit.

Bankers’ acceptances

• Arise from trade finance: an exporter draws a time draft on the importer’s bank; when the bank “accepts,” it becomes obligated to pay at maturity.
• The accepted draft can be sold at a discount to investors.
• Credit risk is that of the accepting bank rather than the importer.
• Particularly relevant in international trade where counterparties may not know each other well.

These instruments underpin day-to-day liquidity management in the financial system and are key benchmarks for short-term interest rates.

Key Term: discount rate basis
A quotation convention where yield is computed as the annualized discount (difference between face value and price) divided by face value. Key Term: add-on rate basis
A quotation convention where yield is computed as the annualized interest divided by the price (amount invested); the interest is “added on” to principal at maturity.

Repos: Mechanics, Motivation, and Structure

Repurchase agreements (repos) are essential sources of short-term funding and liquidity, especially for banks and primary dealers. They function as collateralized loans, though structured legally as a paired sale and repurchase.

• First leg (start leg): The repo seller (typically a dealer or bank) sells a security to the repo buyer (cash lender) and receives cash.

• Second leg (close leg): At the repo's maturity (often overnight, but can be longer), the seller repurchases the security at a pre-agreed higher price, paying the lender principal plus interest (the repo interest).

Economically, the cash lender has extended a collateralized loan; the securities seller has borrowed cash against collateral.

Key Term: repo rate
The implicit interest rate on a repo transaction, based on the difference between the sale and repurchase prices, annualized over the life of the repo.

If:

• $P_0$ = initial cash received (sale price),
• $P_1$ = repurchase price (cash paid back),
• Days = repo term in days,
• Year = 360 or 365 (market convention),

then the repo rate $r_{\text{repo}}$ on an add‑on basis is:

$r_{\text{repo}} = \frac{\text{Year}}{\text{Days}} \times \frac{P_1 - P_0}{P_0}$

The repurchase price is:

$P_1 = P_0 \times \left(1 + r_{\text{repo}} \times \frac{\text{Days}}{\text{Year}}\right)$

The security transferred serves as collateral for the cash lender, reducing credit risk relative to unsecured borrowing. Common repo collateral includes:

• Government bonds and Treasury bills.
• High‑quality agency and supranational bonds.
• Sometimes high‑grade corporate bonds or other liquid securities.

Economic uses of repos

Repos are widely used by institutions to:

• Obtain funding at relatively low cost: The securities seller/borrower can often borrow at a lower rate than on unsecured loans because the lender holds collateral.

• Invest excess cash securely and flexibly: The cash buyer/lender earns the repo rate and holds high‑quality collateral, often with overnight liquidity.

• Finance securities inventories: Dealers fund their bond inventories through repos rather than longer-term debt.

• Support trading and hedging strategies: Repos allow short-selling (borrowing securities to sell) and basis trades between cash bonds and derivatives.

• Implement monetary policy: Central banks use repos and reverse repos to add or drain reserves and steer short-term interest rates.

Key Term: reverse repo
The same transaction viewed from the cash lender’s standpoint: the lender buys securities today and agrees to sell them back later at a higher price.

If one party enters into a repo (borrowing cash against securities), the counterparty has entered into a reverse repo (lending cash against securities).

Key Term: haircuts (repo margin)
The discount applied to the market value of collateral in setting the cash amount lent. It protects the lender against declines in collateral value or counterparty default.

For example, with a 2% haircut, a bond worth 100 is financed with 98 of cash. If the borrower defaults and the bond price falls slightly, the lender still expects to be fully covered.

Worked Example 1.1

A bank needs to invest CHF20 million for one week and agrees to a repo with a securities dealer. The collateral is Swiss government bonds, market value CHF20.4 million, and the repo rate is 1.5% (annualized, 360‑day basis). What cash amount will the bank receive at maturity?

Answer:
The bank is the cash lender entering a reverse repo. The repo interest for 7 days is:

$> \text{Interest} = \text{Principal} \times r_{\text{repo}} \times \frac{\text{Days}}{\text{Year}}$

$> \text{Interest} = 20{,}000{,}000 \times 0.015 \times \frac{7}{360} = 5{,}833\ \text{(CHF, rounded)}$

The dealer repurchases the bonds at:

$> \text{Repurchase price} = 20{,}000{,}000 + 5{,}833 = 20{,}005{,}833\ \text{CHF (rounded)}$

The dealer delivers CHF20,005,833 to the bank at maturity and receives back the bond collateral.

Note that the collateral’s market value (CHF20.4 million) exceeds the cash principal (CHF20 million). This implicit haircut (about 1.96%) provides protection to the bank.

Types of Repurchase Agreements

Repos can be classified by several characteristics that affect their risk and pricing.

By tenor (maturity)

Key Term: overnight repo
A repo with an original maturity of one business day. Key Term: term repo
A repo with a fixed maturity longer than overnight (e.g., one week, one month, three months).

• Overnight repos: Mature the next business day; widely used for daily liquidity management.

• Term repos: Have a specified longer maturity. The repo rate is fixed for the term.

• Open (on‑demand) repos: No fixed maturity; either party can terminate on short notice (e.g., one day). The repo rate may be reset daily.

By collateral and market structure

• Collateral type:

  • General collateral (any security meeting broad eligibility criteria, usually government bonds).
  • Specific collateral (a particular security; repos for “specials” may trade at lower repo rates because there is demand to borrow the specific security).

• Settlement method:

  • Delivery versus payment (DvP): collateral is transferred against simultaneous cash payment through a securities settlement system.
  • Hold‑in‑custody: collateral remains in the borrower’s account but is pledged to the lender (greater operational and legal risk).

Key Term: tri-party repo
A repo arrangement where an independent third-party agent (often a custodian bank or clearing house) manages collateral selection, valuation, settlement, and margining between the two principals.

In bilateral repos, the two counterparties manage collateral directly between themselves. In tri‑party repos, the tri‑party agent holds the collateral and ensures that eligibility, haircuts, and margin calls are followed according to an agreed schedule.

Repo versus unsecured money market borrowing

A key syllabus point is to distinguish repo financing from unsecured borrowing, such as:

• Interbank deposits.
• Commercial paper issuance.
• Unsecured bank loans.

In an unsecured transaction, the lender has only a contractual claim on the borrower. In a repo, the lender additionally has legal rights over collateral. As a result:

• Repo rates are usually lower than rates on comparable unsecured loans.
• Haircuts and margining are used to manage collateral risk.
• The credit quality of the collateral and market liquidity strongly influence repo terms.

Risks in Repo and Money Market Transactions

Despite their perceived safety, money market and repo instruments present several risks.

Counterparty (credit) risk

• In repos: The main risk is that the securities seller (cash borrower) fails to repurchase the collateral at maturity. The lender then must sell the collateral in the market and may incur a loss if its value is insufficient or illiquid.

• In money market instruments: Investors in commercial paper or CDs face the risk that the issuer may default on paying interest or principal at maturity.

Mitigation:

• High‑quality counterparties and collateral.
• Adequate haircuts.
• Daily marking‑to‑market and margin calls (variation margin) when collateral values move.

Collateral risk (market and concentration risk)

Collateral may:

• Fall in market value due to interest rate or credit spread changes.
• Become illiquid or difficult to sell in stressed markets.
• Be subject to concentration risk if a lender holds too much of a single issuer or sector.

Haircuts are set higher for more volatile or less liquid collateral. Margining agreements often require:

• Initial margin: extra collateral at the start of the repo (the haircut).
• Variation margin: additional collateral if the market value of collateral falls.

Liquidity and rollover risk

• For borrowers: Reliance on very short‑term funding (e.g., overnight repos or rolling commercial paper) can be risky if markets freeze and positions cannot be rolled over at reasonable rates.

• For lenders/investors: Some money market instruments may become illiquid, making it difficult to sell before maturity without a price concession.

Liquidity risk is magnified for:

• Lower‑quality issuers.
• Longer‑dated instruments.
• Collateral that is complex or not widely traded.

Legal and documentation risk

• Repo documentation must clearly specify:
  • Ownership transfer of collateral.
  • Rights upon counterparty default.
  • Close‑out netting arrangements.

If legal documentation is weak or not enforceable in a jurisdiction, there is risk that a repo could be re‑characterized as an unsecured loan, or that collateral cannot be seized promptly.

Operational and settlement risk

Operational failures may include:

• Incorrect or late transfer of collateral or cash.
• Errors in collateral allocation or substitution.
• Failures in daily marking‑to‑market or margin calls.

Sound operational procedures, reconciliation, and reliable settlement systems reduce these risks.

Interest rate and reinvestment risk

• Money market instruments have low, but not zero, price sensitivity to interest rates.
• Investors rolling over short-term instruments face reinvestment risk: future rates may be lower than current rates.
• Issuers face refinancing risk: future rates may be higher.

Money Market Yield Measures and Quoting Conventions

Money market instruments use different yield conventions. Understanding these is important for comparing returns and performing calculations.

Repurchase agreement mechanics present the start leg, collateral holding period, and maturity settlement at P1 equal to P0 plus interest.

For Level 1, focus on:

• Discount rate basis (commonly for Treasury bills, commercial paper, bankers’ acceptances).
• Add‑on rate basis (commonly for CDs, repos, and many reference rates).
• Bond‑equivalent yield (standardized add‑on yield on a 365‑day basis).

Key Term: bond equivalent yield
A money market yield stated as an annualized add‑on rate using a 365‑day year, enabling comparison with yields on bonds and other investments.

Discount instruments

Discount instruments (e.g., many T‑bills and commercial paper issues) are quoted at a discount rate $DR$:

$DR = \frac{\text{Year}}{\text{Days}} \times \frac{FV - PV}{FV}$

• $FV$ = face (maturity) value.
• $PV$ = current price (amount paid now).
• Days = days to maturity; Year = 360 or 365 (depends on market).

Rearranging, the price is:

$PV = FV \times \left(1 - DR \times \frac{\text{Days}}{\text{Year}}\right)$

The discount rate understates the investor’s true rate of return because the discount is divided by $FV$ rather than the amount actually invested $PV$.

Add-on instruments

Add‑on instruments (e.g., CDs, many repos, and reference rates such as LIBOR‑like rates) quote an add‑on rate $AOR$:

$AOR = \frac{\text{Year}}{\text{Days}} \times \frac{FV - PV}{PV}$

Rearranging, the price is:

$PV = \frac{FV}{1 + AOR \times \frac{\text{Days}}{\text{Year}}}$

and:

$FV = PV \times \left(1 + AOR \times \frac{\text{Days}}{\text{Year}}\right)$

The add‑on rate is directly comparable to annualized interest rates on loans.

Comparing instruments using bond-equivalent yields

Because different instruments use different day-counts and quote bases, analysts often convert all money market yields to a bond‑equivalent yield:

• Expressed as an add‑on rate.
• Uses a 365‑day year.

This allows proper comparison across instruments.

Worked Example 1.2

An investor buys commercial paper with a face value of $500,000 at 98.5% of face for 90 days on a 360‑day discount basis. What is the annualized discount yield?

Answer:
The price paid is:

$> PV = 0.985 \times 500{,}000 = 492{,}500$

The discount (difference between face value and price) is:

$> \text{Discount} = FV - PV = 500{,}000 - 492{,}500 = 7{,}500$

The discount rate on a 360‑day basis is:

= \frac{360}{90} \times \frac{7{,}500}{500{,}000} = 4 \times 0.015 = 0.06$$ So the quoted annualized discount yield is 6.0% per annum on a discount basis.

The investor’s actual rate of return (on PV) is slightly higher than 6%, because the discount is divided by the price paid rather than the face value.

Worked Example 1.3

A bank issues a 90‑day certificate of deposit (CD) with a principal amount of EUR20 million and a quoted add‑on rate of 0.12% per year on a 365‑day basis. What redemption amount will the bank pay at maturity, and what is the investor’s euro interest income?

Answer:
For an add‑on rate, the redemption amount is:

$> FV = PV \times \left(1 + AOR \times \frac{\text{Days}}{\text{Year}}\right)$

Here:

• $PV = 20{,}000{,}000$
• $AOR = 0.0012$
• Days = 90, Year = 365

$> FV = 20{,}000{,}000 \times \left(1 + 0.0012 \times \frac{90}{365}\right)$

$> FV \approx 20{,}000{,}000 \times \left(1 + 0.000296\right) \approx 20{,}005{,}918$

The investor receives EUR20,005,918 at maturity. The interest income is:

$> \text{Interest} = FV - PV = 20{,}005{,}918 - 20{,}000{,}000 = 5{,}918\ \text{EUR}$

This matches the add‑on rate formula: interest equals principal times the fraction of the year times the annualized rate.

Key Term: certificate of deposit (CD)
A bank-issued time deposit paying interest on an add‑on basis, often negotiable in the money market for large denominations. Key Term: commercial paper
(repeated for emphasis in yield context) Short-term corporate debt that may be quoted on a discount or add‑on yield basis, depending on the market. Key Term: Treasury bill (T‑bill)
A zero‑coupon government security typically quoted on a discount rate basis; price is less than face value, and the investor’s return is the discount.

Exam Warning: In repo contracts, if the collateral value falls sharply and the seller cannot provide extra margin, the lender may face loss even though there is collateral. Always consider the sufficiency and liquidity of the collateral, not just the nominal haircut. Similarly, when comparing money market instruments, be careful to distinguish between discount yields and add‑on (bond‑equivalent) yields—quoting conventions can make two instruments look comparable when their true returns differ.

Summary

• Money market instruments (T‑bills, commercial paper, CDs, bankers’ acceptances) and repos are essential tools for managing short-term funding, liquidity, and low‑risk investment.

• A repo is economically a secured short-term loan structured as a sale and forward repurchase of securities; the repo rate compensates the cash lender.

• For one party the transaction is a repo; for the counterparty it is a reverse repo.

• Haircuts (repo margins), high‑quality collateral, daily marking‑to‑market, and margin calls reduce counterparty and collateral risk in repos.

• Money market instruments use different yield conventions:

  • Discount rate basis (discount divided by face value).
  • Add‑on rate basis (interest divided by price).
  • Bond‑equivalent yields (add‑on, 365‑day basis) facilitate comparisons.

• Risks in repo and money markets include counterparty, collateral, liquidity, legal, operational, interest rate, and rollover risk; understanding how these arise and how they are mitigated is important for the exam.

Key Point Checklist

This article has covered the following key knowledge points:

• Describe the structure and typical uses of repos and money market instruments for short-term funding and liquidity management.
• Distinguish between repo lending (secured) and other short-term money market instruments such as commercial paper and CDs (often unsecured).
• Explain the economic rationale for repos, including lower funding costs due to collateralization and the ability for investors to earn secured short-term returns.
• Identify and explain key risks in repo and money market transactions: counterparty, collateral, liquidity, legal, and operational risk.
• Recognize how collateral quality, haircuts, tri‑party arrangements, and tenor affect repo risk and pricing.
• Calculate basic repo cash flows (interest and repurchase price) given a repo rate and term.
• Calculate and interpret discount yields and add‑on yields on money market instruments, and understand the meaning of a bond‑equivalent yield.

Key Terms and Concepts

• money market instruments
• repurchase agreement (repo)
• Treasury bill (T-bill)
• commercial paper
• certificate of deposit (CD)
• bankers’ acceptance
• discount rate basis
• add-on rate basis
• repo rate
• reverse repo
• haircuts (repo margin)
• overnight repo
• term repo
• tri-party repo
• bond equivalent yield
• Treasury bill (T‑bill)