In Section 1.3 it was mentioned that an investor is able to short stock he does not own. However, this principle where the investor borrows stock to subsequently short it comes at a certain cost and is often referred to as ‘repo’.35 Repo stands for ‘repurchase agreement’ and means that the lender agrees to sell the stock with the agreement to buy it back at a specified price36 somewhere in the future. The lender always has the right to call the stock back.
In this chapter the definition of repo will be discussed, as will be its implications to the option market.
13.1 A REPO EXAMPLE
Consider an investor who is bearish (negative) on the stock Ahold. In this case he could short the stock Ahold at the prevailing market price, in which case he will benefit if Ahold decreases in value. However, for this strategy he would have to borrow the stock which would come at a certain cost. This cost is usually around 10 basis points (bps)37 a year of the notional borrowed, if it is an easy borrow in which case it is referred to as ‘general collateral’ (gc).
Suppose the investor decides to short 100,000 shares of Ahold at $10. If the lender charges him 10 bps per year, it would cost him $1,000 × 10) a year to have this position on.
This is just a simplified example of the mechanics of repo. In reality, there is a very sophisticated repo market to borrow and lend stocks. ...