OVERVIEW OF REPO TRADING AND THE FUTURES CONTRACT IMPLIED REPO RATE
The repo desk will have a central role on the trading floor, supporting the fixed-interest sales desk, hedging new issues, and working with the swaps and over-the-counter (OTC) options desks. In some banks and securities houses it will be placed within the Treasury or money market areas, whereas other firms will organise the repo desk as part of the bond operation. It is also not unusual to see equity repo carried out in a different area from bond repo.
In this chapter we introduce the approach to funding using repo. In the second part of the chapter we discuss the concept of the futures bond basis, which centres around the implied repo rate.
Positive yield curve environment
When the yield curve is positively sloped, the conventional approach is to fund at the short end and lend at the long end of the curve. In essence, therefore, a bank would borrow, say, 1-week funds while simultaneously lending out at 2-week or 1-month. This is known as funding short
and is illustrated at Figure 6.1
A bank can effect the economic equivalent of borrowing at the short end of the yield curve and lending at the longer end through repo transactions, in our example a 1-week repo and a 6-month reverse repo. The bank then continuously rolls over its funding at 1-week intervals for the 6-month period. This is also known as creating a tail; here the ‘tail’ is the gap between 1 week and 6 months, the ...