An Introduction to Repo Markets, Third Edition

Chapter 2

MARKET BACKGROUND

Repo is organised as part of the money markets, because the term of repo trades falls within 1 year. As essential background we need to be familiar with money market products. In addition, as bonds are the most common form of repo collateral, we need to be very familiar with bond instruments as well. This chapter provides the necessary detail, including a discussion on discounting and present value. Readers already familiar with money market and bond market instruments can go straight to Chapter 3.

DISCOUNTING AND PRESENT VALUE

The principles of compound interest have for some time now been used to illustrate that £1 received today is not the same as £1 received at a point in the future. Faced with a choice between £1 today or £1 in 1 year’s time we would not be indifferent, given a rate of interest of, say, 10% per annum. Our choice would be between £1 today and £1 plus 10p a year from now – the interest on £1 for 1 year at 10% per annum. The further one goes into the future, the greater will be requirement to be compensated for interest foregone, because of the effect of compounding.

Compounding

In compounding we seek to find a future value given a present value, a time period and an interest rate. If £100 is invested today (at time t₀) at 10%, then 1 year later (t₁) the investor will have £100 ☓ (1 + 0.10) = £110. If he leaves the capital and interest for another year he will have at the end of year 2 (t₂):

The outcome of the process of compounding ...