The ‘HedgeRepo’ concept: Using credit derivatives as repo collateral

37Derivatives Use, Trading & Regulation Volume Eleven Number One 2005

Derivatives Use

The ‘HedgeRepo’ concept: Using credit

derivatives as repo collateral

Kumar Kakumanu*, Izzy Nelken and Moorad Choudhry

*Global Tech Inc, 167 Main St, Suite 1A, Metuchen, NJ 08840, USA.Tel. �1 (732) 910 1079; E-mail: [email protected]

Received: 7th January, 2005

Kumar Kakumanu works for Globe Tech, Inc, where he specialises in enterprise application security,architecture and risk management for the financial industry.

Izzy Nelken is President of Super Computer Consulting Inc, which specialises in risk management andmodelling of complex derivatives. He is a lecturer at the Department of Mathematics, University of Chicago,and has authored books on credit derivatives and exotic options. He can be contacted via e-mail [email protected]

Moorad Choudhry works in investment banking in the City of London and is a Partner in YieldCurve.com. Heis a visiting professor at the Department of Economics, London Metropolitan University, a senior fellow at theCentre for Mathematical Trading and Finance, Cass Business School, and a fellow of the Securities Institute.He is author of ‘The Bond and Money Markets: Strategy, Trading, Analysis’ and ‘Structured Credit Products:Credit Derivatives and Synthetic Securitisation’. He can be contacted via e-mail at [email protected]

Practical applications

HedgeRepo is most practical in markets where there are mature repo and derivativemarkets. It has applicability in a variety of repo financing deals such as equity repos, creditrepos and commodity repos that involve risky collateral and risky counterparties.

Liquid derivatives, such as exchange traded equity options/futures, and OTC instruments,such as equity index swaps, could be used as additional collateral in equity repo deals.Similarly, credit default swaps — the most liquid instruments in the credit derivativesmarket — could be used as additional collateral in credit repo deals.

Lower rated and risky borrowers, such as hedge funds with high repo costs, would beimmediate beneficiaries of HedgeRepo. Hedge funds could use any existing derivativepositions as additional collateral in their repo financing of risky securities such as equites,high yield corporate or emerging market bonds. Other beneficiaries would be marketparticipants with positions in both derivative and repo markets. Examples are: traders andarbitrageurs involved in relative value trades between cash and derivatives markets; assetmanagers in the high yield debt markets; and derivative/cash market dealers who hedgetheir positions and also use the repo market.

Derivatives Use,

Trading & Regulation,

Vol. 11 No. 1, 2005,

pp. 37– 57

� Henry StewartPublications,

1357-0927

Abstract

This paper discusses the concept of theHedgeRepo (trademarked and patent pending —HedgeRepo shall mean HedgeRepoTM)paradigm, which integrates derivative-basedhedging, repo financing, collateral andcounterparty risk management in a singlerepo-style instrument. This paper discusses aparticular example of this paradigm, which is theuse of credit derivatives — specifically creditdefault swaps (CDSs) — as repo collateral.Integrated collateral and counterparty riskmanagement are performed in repo financing ofhigh yield bonds, and the qualitative andquantitative benefits of such integration are alsoexplored. The paper is organised in two parts.The first part provides some backgroundinformation on repo trades and CDSs. It alsodescribes the trends in the marketplace and theshortcomings in current risk management practicein repo trades. The second part discussesHedgeRepo and related information. The benefitsof HedgeRepo are explained and numericalexamples of repos are provided where CDSs areused as additional collateral in financing aportfolio of high yield bonds. These illustrate theadvantages of applying the HedgeRepo concept.The potential practical uses of HedgeRepo in thecontext of CDSs and high yield bond repomarkets are listed.

BACKGROUND

Credit default swaps

The primary credit derivative instrumentis the credit default swap. Credit defaultswaps1 (CDSs) have also been calledbankruptcy insurance. The structure ofthis derivative is quite simple. There arethree parties, two of which are involvedin the trade as counterparties. The‘protection buyer’ pays a periodicpremium (eg quarterly) (see Figure 1).The premium is pre-determined at Xbasis points (6ps) of the notional value ofthe deal. The ‘protection seller’ standsready to compensate the buyer in case ofa ‘credit event’ (eg default) on the‘reference credit’. The reference credit isnot part of the deal; it merely serves as areference.

In the case of a credit event, theprotection seller will pay the differencebetween par and the recovery value of thereference credit — ‘cash settlement’.Alternatively, the protection seller willaccept a bond, from a pool of ‘deliverableobligations’, from the buyer and pay thebuyer a par amount, called ‘physicalsettlement’. Obviously, upon default, thesubsequent premium payments shall cease,

38 Kakumanu, Nelken and Choudhry

Additionally, repo service providers could use HedgeRepo to enhance their productportfolio and expand repo business to riskier asset classes and riskier counterparties withoutnecessarily increasing risk for lenders.

Extensions to existing repo and derivative legal agreements would be required toimplement HedgeRepo. Further, the extensions would have to be standardised or endorsedby industry organisations in order to commoditise HedgeRepo for acceptance by a widervariety of market participants.

liquid credit derivatives. Many other creditderivatives exist, including total returnswaps, credit linked notes and collateraliseddebt obligations.

There are a number of reasons whymarket participants transact business in thecredit derivatives market. The marketallows the ‘unbundling’ of credit risk fromother sources of risk. The credit risk canthen be sold in other markets to other

except for the premium accrued up to thedate of the credit event.

For example, if the reference credit hasdefaulted, and its bond is now worth 20cents on the dollar, the protection sellerwill pay the buyer 80 per cent of thenotional amount of the deal (or pay parand receive the defaulted bond).

Credit default swaps with tenors of fiveyears on large corporate names are the most

39Kakumanu, Nelken and Choudhry

Party A — borrower offunds

Party B — lender offunds

Bond C

Cash

Figure 1: Credit default swap

Figure 2: A vanilla repo deal

Protection seller Protection buyer

Third party reference credit

X bps per annum

Contingency payment in case

of credit event

participants. For example, the protectionsellers can take a view on credit and earnthe premium payment without exposingthemselves to duration, convexity orforeign exchange risks.

Credit derivatives allow protection buyersto hold unacceptable credits in theirportfolios, as these credits are insuredagainst default. It is also possible to take anegative view on a credit and become aprotection buyer without actually shortingthe credit.

Repurchase agreements

Repurchase agreements or repos are simplyshort-term loans, where a security, usually abond, is used as collateral. They areprincipally used to fund bond positions inthe wholesale financial markets, which inturn are used for hedging and arbitragestrategies against derivatives. Reverse repois used to cover short positions. So, repo isimportant for funding and liquiditypurposes, for both long and short assetpositions.

In Figure 2, Party A is borrowing fundsfrom Party B. Party B transfers money toParty A. In return, as collateral, Party Adeposits bond C with Party B.

During the deal, Party A will have topay interest on the borrowed funds to PartyB. In addition, Party A will keep onreceiving the coupons that are paid on theBond C. At the termination of the deal,the funds are returned and the bond is alsoreturned.

Obviously, during the term of thetransaction, Party B is exposed to a defaultrisk of Party A. The repo deal exists, inpart, to reduce this risk. If Party A defaults

during the term of the deal, Party B willkeep the bond.

There is a fundamental risk to the lenderof the funds. If Party A defaults and BondC also defaults, the lender will suffer asubstantial loss. Currently, this risk ismitigated using counterpartyrisk-management measures. These, however,were originally developed for repos ingovernment securities, which are consideredbankruptcy remote. The deficiencies ofthese procedures for risky securities areexplained later.

The HedgeRepo3 concept is to combinethe hedging and repo deals into onepackage. It is most useful in tri-party reposituations involving ‘risky’ securities wherethere is an inherent need for hedging and ahigh margin requirement for a vanilla repodeal.

Tri-party repo

In a tri-party repo deal, there is a globalcustodian. The custodian attempts toprovide the best possible protection forboth borrower and lender participating inthe tri-party programme. The custodianideally keeps the securities in a segregatedaccount, thereby ensuring compliancewith the terms of the tri-party agreement.Once the custodian is satisfied that allstated requirements have been met, asimultaneous exchange of cash versussecurities is executed between the twocounterparties to the deal. Ideally, bothparties receive timely confirmations andreporting of transactions and income. Inthe case of term repos, the custodianmight also be required to mark collateralto market daily, issuing margin calls or


— minimising the risk of failure upon repomaturity

— reducing back-office processing andoperational risks (an important elementof Basel II).

Trends in the marketplace

In recent years, the market hasexperienced tremendous growth in bothderivatives and repo arrangements. Thelatest figures (released in June 2004 bythe Bank for International Settlements(BIS)) estimate the notional value of theover-the-counter (OTC) derivativemarkets at almost US$200 trillion, agrowth of approximately 33 per centfrom 2003.5 The credit derivatives markethas also grown quite quickly. TheInternational Swaps and DerivativesAssociation (ISDA) reports that creditderivative notional amounts now stand at$3.58 trillion.6 This represents ayear-on-year growth of 67 per cent.Credit derivatives, for the purposes of thesurvey, consist of CDSs on individualnames, baskets and portfolios.

The growth in the credit derivativesmarket has been explosive. In 1996, theglobal credit derivatives market was onlyabout $100bn to $200bn in size. TheBritish Bankers Association7 estimates thecredit derivative market at $4.8 trillion insize in 2004, and 2005 growth estimates areas high as $6.5 trillion.

In the high yield market, according tothe Bond Market Association,8 the issuanceof high yield corporate debt grew by 10.7per cent to $49.5bn from $44.8bn as at31st May, 2004, compared with theprevious year.

returns when necessary. For example, theBank of New York is a leading providerof tri-party repos. It processes over$800bn repo transactions on a daily basisworldwide.4

Tri-party repo arrangements reduce theoperational and settlement risks to bothparties. An impartial, highly rated entitytransfers both the cash and the securitiesinstantaneously and is in charge of markingthe deal to market.

The advantages of tri-party repo are:

— extremely low risk— a secure investment vehicle that is not

subject to the volatility of equity-basedmarkets

— a solution to the perpetual dilemma ofwhere to allocate short-term cash

— a way to optimise large influxes of cashwithout a long-term commitment

— no cost: for the cash investor, such as apension fund, there is no need for anyspecial infrastructure or transactionalcosts.

There are a variety of tri-party repocustodians and slight differences in the levelof services offered. Typically, however, thefundamental benefits of the deal include:

— providing an inexpensive source offunding for brokers/dealers whileenhancing yield over other moneymarket instruments for investors

— an alternative to a money marketinvestment vehicles

— handling mid-office andrisk-management procedures, whileproviding pre-trade compliance


The future for the credit derivativesmarket is enormous, given that theunderlying global debt (according to theBIS) is estimated to be $35 trillion inprincipal outstanding. In addition, the BaselCommittee on Banking Supervision isexpected to implement new rules by2006/7. The Basel II rules will requirerigorous capital adequacy standards for riskmanagement. Credit derivatives are themost preferred products for such riskmanagement.

Meanwhile, the latest ISMA surveyreports that the European repo marketshave grown an estimated 19 per centyear-on-year ending June 2004 and arenow valued at close to e4.561 trillion.9 Asfor tri-party repos, ISMA reports:

‘In the latest survey, 10.9 per cent oftotal outstanding business was settledthrough tri-party repo arrangements,largely sustaining the dramatic increase inshare seen between December 2003(11.2 per cent) and June 2003 (6.2 percent).’

The Federal Reserve Bank of NY reportsthat the market size in the US is $4.5trillion, an increase of 10 per cent from lastyear with approximately one-third intri-party arrangements. Additionally, Basel IIhas favourable treatment for collateralisedfinancing, which is an incentive for growthin repo markets.

Although most repo trades are doneagainst government bonds, which are riskfree or close to risk free, a significantportion of the deals are done againstcorporate debt. According to ISMA, the

credit quality of the collateral has beendeclining:

‘The share of government bonds is on ageneral trend of decline. It was 87.4 percent in June 2004 compared with 88.1per cent in June 2003. Governmentbonds accounted for only 36.3 per centof outstanding tri-party repo contracts.

This change largely reflected increasesin the shares of non-government bondcollateral in the UK, Germany and, to alesser extent, Italy. The share of equitycontinued to increase, although still froma low base, to account for 1.8 per centin June 2004, though it fell back slightlyfrom 2.2 per cent of the total value ofcollateral outstanding in December 2003.’

According to Godfried de Vidts, chairmanof the European Repo Council, ‘the size ofhigh yield or sub-investment grade bondsin European tri-party is presently estimatedto be around e40bn or approximately 10per cent of total tri-party repo share. Equityrepo that also includes equity linked debtsuch as convertible bonds is estimatedaround e120bn.’ Additionally, use of BBBrated or lower collateral grew10 from 8 percent in 2001 to 18 per cent in 2003 at justone tri-party provider in Europe.

Most of the repo trades are quite short,one month or less. Very short-term repos(under one week), however, seemed to bein decline towards the 2003 year end.According to ISMA’s December 2003 andJune 2004 surveys:

‘The bulk of repo activity continues tobe in terms of one month or less (68.1


and a wider variety of repo collateral.(5) The credit quality of the repo collateral

has been declining (owing to increasinguse of high yield debt as collateral).The potential for further growth is stillconsiderable, since at present, the highyield repo collateral is only a smallfraction of the total outstanding highyield debt.

(6) The prevalence of very short-term repodeals is declining (average term tomaturity of repo deals is increasing).

(7) The use of tri-party repo arrangementsis increasing, accompanied by growth in‘risky’ collateral in tri-party deals.

The concept of HedgeRepo is at thecentre of all these trends. Integratingderivative-based risk management withrepo-style deals for risky securities enablesderivatives to be used as repo collateralalong with underlying risky securities.

While doing so, it provides a number ofcost benefits such as reduced repo interestrates, haircuts, margin calls and operationalcosts. It also reduces overall risk, regulatorycapital requirements, eliminates duplicaterisk-management costs between hedging anasset and counterparty risk-managementcosts during a repo financing of the sameasset, increases the risk adjusted return oncapital (RAROC), (or return on riskadjusted capital [RORAC]) and alsoincreases collateral and investing options.The benefit for repo service providers isthat they could do more business withlower credit customers, expand repocollateral to multiple risky assets classes andcross-sell risk management and repofinancing products.

per cent compared with 63.8% inDecember 2003, and 66.8 per cent inJune 2003). The respective patternsestablished in [the] previous Decemberand June were also broadly repeated inDecember 2003 and June 2004.

The overnight repo deals fell from18.7 per cent in June 2003 to 17.3 percent in June 2004. Deals with maturitybetween 7 days and 1 month increasedfrom 26.1 per cent to 28.3 per cent inJune 2004 compared to previous year.Deals with maturity ranging from 3 to 6months increased from 7.1 per cent to7.3 per cent in June 2004 compared to[the] previous year’.

Additionally, in recent times there has beena tremendous growth in the hedge fundindustry. The number of hedge funds11 isexpected to top 10,000 in 2006, withestimated assets in excess of $1.2 trillion.

This section has described several trendsin the marketplace:

(1) There is an increased focus on riskmanagement: tremendous growth in theOTC derivative market and especiallythe credit derivatives market.

(2) Favourable regulatory trends underBasel II should exist for use of creditderivatives and collateralised transactionslike repo.

(3) The market for risky assets such as highyield debt is growing worldwide. Riskycounterparties such as hedge funds aregrowing in number and the size oftheir assets.

(4) Significant growth in the repo marketsand increasing use of non-government


Using derivatives for credit support

There are numerous examples in whichderivatives are used for credit support inthe context of a loan.

Consider an airline that applies for a loanat the bank. Owing to the fact that thefinancial situation of the airline is quitevolatile and depends on the price of oil,the bank will charge it a high interest rate.Assuming that the airline purchases acommodity call option on the price of oil(from the same bank), the stability of itscash flows should be improved. In this case,the bank could charge a lower rate on theloan. It is quite possible that the lower rateon the loan would be sufficient to pay forthe price of the option.

Several prime brokerages allowconvertible bond hedge funds to create aposition of long convertible bonds andshort shares on margin. The same traderscan, in addition, purchase a creditderivative on the same convertible bond(in the form of convertible bond assetswap). If the credit derivative is purchasedfrom the same broker, the marginrequirements are much reduced. Moreprecisely, the broker will require the samerate but on a lower balance. This is onlytrue if the positions in the strategy residewith the broker in a prime brokeragecustody account or in a total return swap.In the language of prime brokerage, this iscalled cross-margining.

On a typical convertible bond coupledwith a short equity position, the rates on atotal return swap might be 5–10 per cent.Adding a credit derivative reduces the rateto 4–6 per cent.

Additional benefits include that:

— Removing credit risk is good for theclient as well as for the prime broker.

— The portfolio is going to be less volatilethan before, and that is good for all.

— It is especially important to primebrokers in developing long-termrelationships.

Shortcomings of current

risk-management practices in

repo trades

Traditional methods for counterparty andcollateral risk management work well withdefault-free collateral such as governmentbonds. These methods do not work so wellwith volatile securities such as riskycorporate bonds or equities. Currently, repoproviders eliminate certain types of collateralusing collateral eligibility criteria. Theyattempt to reduce collateral risks by imposingconcentration limits and maintain collateraldiversification using different types ofcollateral. Another common technique is torequire over-collateralisation through the useof haircuts and margins. These techniquesare useful, but only to a limited extent andnot without some undesirable side effects,especially during a market decline.

For junk bond deals by risky borrowerssuch as hedge funds, higher haircuts are amust, since, without them, it is too riskyfor the lender. Conversely, they areexpensive for the cash borrower becausethey impose an additional financing cost.Additionally, haircuts do not protect theborrower’s investment either. For thelender, haircuts alone do not provideadequate security. The lender still has torely on daily mark-to-market proceduresand margin calls to manage counterparty


restricted, it becomes harder to borrowwhich, in turn, reduces market liquidity.Conversely, market liquidity is assisted as itbecomes easier for market entities to obtainfunding for their asset pools.

Other traditional counterpartyrisk-management methods, such as collateraldiversification, also have some problems.For example, a collateral provider in therepo, while trying to address counterpartyrisk for one type of collateral, is nowforced to tie up another type of collateralwhich may or may not meet his objectives.Collateral concentration limits — as thename obviously suggests — limit the size ofany particular collateral, and consequentlyimpose an additional constraint for thecollateral provider, though it benefits thecollateral receiver. Eligibility criteria areanother restriction for the collateralprovider which limit the types of collateralthat could be financed using repo.

Currently, derivatives market and repomarkets are separately well developed.There is no process or method, however,for using derivatives in the context of arepo deal. Derivative instruments such asCDSs or total return swaps provide betterprotection for risky repo collateral such asWorldcom or Parmalat bonds. Currently,however, there is no easy or establishedway to use them in a repo context.

HEDGEREPO

HedgeRepo extends the existing repomodels to provide integrated hedging,collateral and counterparty risk managementin a single repo style instrument. Itprovides derivative-based custom hedging

risk and ensure the adequacy of collateral.During a market meltdown, there could besufficient collateral decline intraday orbetween mark-to-market events to increasethe counterparty risk exposure dramatically.Margin maintenance is the primary sourceof counterparty risk and back office costsfor the lender. Haircuts or traditionalmark-to-market or margin calls would nothave helped if Xerox, Enron or Parmalatbonds had been used as collateral by a lowrated counterparty. Hence, in the presentsystems, repo lenders limit themselves todoing business with higher-ratedinstruments.

A counterpoint argument could be madethat imposing high initial marginrequirements could reduce the scope forfrequent margin calls. High initial marginrequirements, however, are still expensivefor the borrower. In addition, even withhigh initial margins, frequent revaluationand monitoring of counterparties would benecessary. The revaluation of collateralisedpositions requires counterparties withrapidly declining positions to come up withadditional collateral at short notice, whichmay, in turn, force them to liquidate otherpositions. Therefore, margin calls, whenmade, would be more frequent and likelyto generate liquidity pressures for providersof collateral. This is inefficient and wastefulof time and resources. It is always better tohave the lowest-possible haircut levels(which allows for lower funding costs forthe cash borrower) and less-frequent margincalls.

Restricting collateral types becomes aproblem in times of market correction orilliquidity. As the accepted collateral is


of the short and/or long position in volatilecollateral, while simultaneously using thesame hedges to manage collateral andcounterparty risk within the context of arepo deal.

The motivation behind HedgeRepo iscost-efficient integration of repo and riskmanagement of risky securities. If the samesecurity or portfolio is hedged usingderivatives and also used as repo collateral,why pay twice for risk-management, ie payonce for hedging outside the repo deal andpay again for counterparty risk managementinside the repo deal in the form of ahaircut? In the current repo systems, thereis duplication of risk-management costs andalso increased complexity, because there isno way to hedge and finance/borrow riskysecurities in a single package. HedgeRepoavoids this double cost of separate riskmanagement in hedging andfinancing/investing in volatile collateral byproviding a single integrated instrument,with the additional benefit of convenienceand simplicity. Explicitly, HedgeRepoenables a hedge, put on forrisk-management purposes, also to be usedas repo collateral.

Though the HedgeRepo could be usedin any repo-style deals (including securitieslending, bilateral, tri-party repo etc), it ismost useful in tri-party term repo situationsinvolving volatile securities or portfolios.HedgeRepo is more beneficial tolonger-term repos than for overnight repodeals, owing to the fact that it is best tomatch the terms of the repo deal with thehedge. Since tri-party repo custodiansalready handle many collateral managementtasks, and also have the necessary repo

infrastructure, it is most efficient for themto provide a value added risk-managementservice for the same repo collateral.

Consider the following two scenarios:

(1) The borrower does not have a hedgebut will be motivated to put on thehedge through better terms of the repodeal. The lender will offer better terms,as collateral which consists of a bondand a hedge is less risky than one thatconsists of the bond by itself.

(2) The borrower already has a pre-existinghedge (eg a CDS) on the collateralbond. In this case, the bond and thehedge will be combined to form thecollateral.

HedgeRepo also makes it possible to hedgethe credit risk of the borrower or even ajoint hedge to improve the credit risk ofthe borrower and the collateral.

Case study

Suppose a dealer wants to borrow funds.The dealer is willing to place one or more ofthe bonds in his/her portfolio as collateral.An institutional investor is ready to lend themoney but is concerned about the creditquality of the dealer as well as the poorcredit quality of the bonds offered ascollateral.

This could be handled by

(1) refusing the deal(2) charging a high interest rate on the loan(3) imposing a high margin and haircut

requirement on the deal.

These three cases are now considered.


Term mismatch

One difficulty in applying credit derivativesto repo trades is that of term mismatch.Most CDSs have a term of five years,whereas repo trades (even term repos) aremuch shorter.

Consider a HedgeRepo trade withcorporate bond collateral. A five-year CDS(most popular and liquid maturity in thecredit default swap market) could be usedto hedge the default risk, even if the termof the repo is three months. If theborrower already has a CDS hedge on thebond, it is simply transferred as part of thecollateral. Otherwise, the borrower mightconsider purchasing a CDS on the bond.

The question is what to do with theCDS at the maturity of the repo. There areseveral possibilities:

(1) The CDS could be sold out and theremaining value recouped as cash.

(2) The CDS could be returned to theborrower, who would continue to holdon to it. This is especially likely if theborrower already had the CDS hedgebefore the deal was started.

Essentially, where a hedge is already inplace, it is highly advantageous for theborrower to use HedgeRepo, since therewould be no additional set-up costsincurred for the hedge to be used as repocollateral.

Comparison

A simple repo can be compared with ahedged repo.

A repo with a particular corporate bondissued by the XYZ Corporation as

Scenario 1

Approving or refusing the deal must bedone on a case by case basis. Typically inthese situations, there are relationshipconsiderations that will favour dealapproval. In that case, the decision that istaken by the institution might not be theoptimal one.

Scenario 2

Charging a high interest rate: the rate mustbe calculated as a function of the amountsinvolved, the tenor of the deal, the creditquality of the counterparty and that of thecollateral.

Scenario 3

Similarly, a sufficiently high marginrequirement could be set on the deal.Again, this will have to be done on a caseby case basis. Setting a high marginrequirement is likely to result in manymargin calls and cause higher administrativeexpenses. Also, requiring higher haircutraises the cost of capital locked up just tosatisfy the margin requirements. Margincalls are uncomfortable for the dealer aswell as the client and may have detrimentalconsequences for the relationship.

HedgeRepo opens the possibility of anothersolution. Use of derivatives will allowtransactions with lower-rated counterpartiesproviding poor quality collaterals. It islikely that the liquid credit derivativemarkets might be able to find a moreefficient way of hedging the counterpartyrisks (arising out of the credit risk of thecollateral) than the single dealer involved inthe transaction would.


collateral might be accomplished with ahigh interest rate.

A repo with a corporate bond and acredit derivative hedge will beaccomplished with a lower interest rate.

It is likely that the cost of the creditderivative will be lower than the differencebetween the two interest rates (and theresulting savings could possibly even financethe portfolio insurance costs). It might becheaper in some cases to purchase thehedge (which actually protects the assetagainst default risk) compared with the costof locking up considerable capital ashaircut. Derivatives offer more precise,efficient and flexible control of risks thanhaircut.

Also, using derivatives as collateral wouldadd value by reducing the haircut amountand frequency of margin calls. A haircut isan additional expense, because it means thatless of the position or portfolio is beingfunded. Margin calls are an administrativeand operational burden for the lender andinconvenient for the borrower, so havingfewer calls during the term of a repowould be welcome from the relationshipperspective.

In addition, there are other points toconsider. The collateral becomes lessvolatile owing to the inclusion of the creditderivative. Hence, there is less dependencyon margin calls to manage counterparty riskdue to collateral volatility. Hedged collateralreduces this risk, not just until the nextmark-to-market event, but for the entirerepo term in a more continuous mannerthan the traditional daily (or at certaindiscrete) intervals of managing risk usingmark-to-market and margin call procedures.It is a more efficient and operationallysimpler one shot deal. Management of repocollateral risk by derivatives reduces thedependence on counterparty riskmanagement via traditional methods andeliminates the requirement for goodcounterparty credit ratings. This is afundamental shift in HedgeRepo comparedwith classic repo.

As such, it makes HedgeRepo attractiveto those market participants who trade orhold lower-quality assets, and it presents awider group of (risky) counterparties totri-party repo agents or repo lenders. Itincreases the range of alternatives forlenders of cash (ie more types of collateral


Table 1: Compare HedgeRepo with classic repo in these different cases

Type of repo Description

Case 1 Vanilla basket repo, no hedge Bond porfolio that is financed but not hedged

Case 2 Vanilla basket repo+hedge(hedge separate from repo)

Bond portfolio that is hedged and then separatelyfinanced using vanilla repo

Case 3 Basket repo with integrated hedgevia HedgeRepo

Bond portfolio that is hedged and financed usingHedgeRepo

49K

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Table 2: Portfolio of high yield bonds — market prices, repo rate, credit default swap (CDS) prices and haircut rates

Bond RatingCashborrowed

Dirtyprice

Repo rate invanilla repro

Repo rate inHedgeRepo

Haircut invanilla repo

Haircut inHedgeRepo CDS price

Market valueof bond collateralwith haircut

GM 8.375% 7/33Ford 7% 10/13ACCR 2004–3 2M7Russia 12.75% 2028Brazil C 8% 4/14Total cash loan

BBBBBBBBBBB�B�

$10MM$10MM$10MM$10MM$10MM$50MM

106.8128107.906499.0125154.5772100.9333

Total portfolio market value

2.35%1.15%2.20%1.40%1.10%

1.80%1.15%2.00%1.40%1.10%

20%20%20%25%25%

5%5%5%5%5%

1.69%1.68%3.35%2.20%4.90%

$12,000,000$12,000,000$12,000,000$12,500,000$12,500,000$61MM

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Table 3: Relative increase in RORAC in HedgeRepo (case 3) versus cases 1 and 2

Type ofrepo Collateral

Repointerestexpenses($)

Cost offunds forhaircut($)

Totalrepocost($)

Totalhedgeexpense($)

Totalrepo &hedgecosts ($)

Incomefrom bondcoupons($)

P&L($)

Increase inP&L inHedgeRepo($)

% increasein P&LHedgeRepo(%)

HaircutCADcharge($)

BondCADcharge($)

Total CADcharge ($) RORAC

% increase ofRORAC inHedgeRepo

Case 1

Case 2

Case 3

Case 1

Case 2

Case 3

Case 1

Case 2

Case 3

Case 1

Case 2

Case 3

Case 1

Case 2

Case 3

Basket Repo Totals

Case 1

Case 2

Case 3

GM 8.375% 7/33

GM 8.375% 7/33

GM Bond + CDS

F 7% 10/13

F 7% 10/13

Ford Bond + CDS

ACCR 2004–3 2M7

ACCR 2004–3 2M7

ACCR Bond + CDS

RUSS 12.75% 2028

RUSS 12.75% 2028

RUSS Bond + CDS

BRZ C 8% 4/14

BRZ C 8% 4/14

BRZ Bond + CDS

5 Bond portfolio

5 Bond portfolio

5 Bond portfolio+5

single name CDSs

58,750

58,750

45,000

28,750

28,750

28,750

55,000

55,000

50,000

35,000

35,000

35,000

27,000

27,000

27,500

205,000

205,000

186,000

15,000

15,000

3,750

15,000

15,000

3,750

15,000

15,000

3,750

18,750

18,750

3,750

18,750

18,750

3,750

82,500

82,500

18,750

73,750

73,750

48,750

43,750

43,750

32,500

70,000

70,000

53,750

53,750

53,750

38,750

46,250

46,250

31,250

287,500

287,500

205,000

N/A

42,270

42,270

N/A

42,015

42,015

N/A

54.875

54,875

N/A

122,500

122,500

N/A

345,410

345,410

73,750

116,020

91,020

43,750

85,765

74,515

70,000

153,750

137,500

53,750

108,625

93,625

46,250

168,750

153,750

287,500

632,910

550,410

235,225

235,225

235,225

194,613

194,613

194,613

166,646

166,646

166,646

257,760

257,760

257,760

247,688

247,688

247,688

1,101,931

1,101,931

1,101,931

161,475

119,205

144,205

150,863

108,848

120,098

96,646

12,896

29,146

204,010

149,135

164,135

201,438

78,938

93,938

814,431

469,021

551,521

–17,270

25,000

–30765

11,250

67,500

16,250

39,675

15,000

107,500

15,000

262,910

82,500

–10.70%

20.97%

–20.39%

10.34%

–69.84%

128.01%

-19.55%

10.06%

–53.37%

19.00%

–32.28%

17.59%

32,000

32,000

8,000

32,000

32,000

8,000

32,000

32,000

8,000

40,000

40,000

8,000

40,000

40,000

8,000

176,000

176,000

40,000

960,000

192,000

192,000

960,000

192,000

192,000

960,000

192,000

192,000

1,000,000

200,000

200,000

1,000,000

200,000

200,000

4,880,000

976,000

976,000

992,000

224,000

200,000

992,000

224,000

200,000

992,000

224,000

200,000

1,040,000

240,000

208,000

1,040,000

240,000

208,000

5,056,000

1,152,000

1,016,000

16.28%

53.22%

72.10%

15.21%

48.59%

60.05%

9.74%

5.76%

14.57%

19.62%

62.14%

78.91%

19.37%

32.89%

45.16%

16.11%

40.71%

54.28%

342.95%

35.49%

294.85%

23.58%

49.58%

153.13%

302.27%

26.99%

133.17%

37.31%

236.99%

33.33%

GM, General Motors; F, Ford; ACCR, Accredited Mortgage Loan Trust; RUSS, Russian; BRZ, Brazilian; P&L, profit & loss; CDS, credit default swaps; RORAC, return on risk

adjusted capital.

tri-party provider could sell CDSs to a lowcredit rated hedge fund which needs tohedge and also repo finance a junk bond.

Numerical example

This section explores specific examples ofthe use of CDSs to support repo trades andillustrates the benefits of HedgeRepo in aquantitative way. The examples computethe relative advantage of HedgeRepo interms of the increase in RORAC comparedwith the classic (or vanilla) repo.

Vanilla repo can be compared withHedgeRepo in the three cases shown inTable 1. Case 1 is the typical classic repo.Case 2 involves a bond or a portfolio and a

to take and greater variety of counterparties— via tri-party or direct — to trade with).The widening of the market for potentialborrowers and lenders in repo is a keyadvantage of HedgeRepo. For repo serviceproviders, benefits come from increasedbusiness volumes due to flexibility andexpansion in collateral variety to risky assetsand/or risky repo counterparties withoutnecessarily increasing the credit risk for thelender and without raising costs for theborrower.

Repo providers could also cross-sellderivative risk management and repofinancing services between repo andrisk-management customers. For example, a


Table 4: Terms of the repo and HedgeRepo deals

Term Value

Cash loan for each bond $10m

Total market value of portfolio $61m

Total cash loan from basket repo $50m

Repo term 3 months

Credit rating of borrower BBB

Credit rating of lender AA

Repo rate for BBB borrower Repo rate for AA borrower�25bps

Baseline repo rate in HedgeRepo LIBOR�10bps15

Baseline haircut in HedgeRepo 5%

Non repo funding rate for borrower 3%

CDS notional for each bond $10m

Type of hedge for each bond 5 Year CDS

Hedge term 3 months

Haircut CAD rate 1.6%

Bond CAD rate 8%

Bond�CDS CAD rate 1.60%

CAD, Capital Adequacy Directive; CDS, credit default swap.

separate credit default swap which is notincluded as repo collateral. Case 3 isillustrative of applying HedgeRepo.

Single bond repo

As a simple example, first compare thecosts of financing a General Motors (GM)bond using classic repo with those of aHedgeRepo from the perspective of thecash borrower in the three cases shown inTable 1. Later, a similar comparison isperformed for the high yield portfolioshown in Table 2.12

An investor holds the GM 8.375 percent bond which matures in July 2033.The three month repo rate for this bond is2.35 per cent. The premium on the CDSis 169.08 bps. A $10m cash loan isobtained using the GM bond as repocollateral.

The GM bond section of the spreadsheetin Table 3 shows that, in HedgeRepo, thehaircut is only 5 per cent and the repo rateis 1.8 per cent. A number of benefits areachieved by the borrower in HedgeRepowhen compared with case 1 (classic repowith no hedge).

— The borrower is now able to insure the$10m junk bond position for creditdefault risk.

— Though the insurance costs an additional$42,270, it reduces the total profit byonly $17,270 (10.7 per cent) from$161,475 to $144,205. This is becauseof the reduction in repo interest expenseand haircut cost of capital when CDS isincluded as additional collateral inHedgeRepo.

— Repo interest expense decreases by

$13,750 (23.4 per cent) from $58,750 to$45,000.

— The cost of funds for haircut decreasesby $11,250 (75 per cent) from $15,000to $3,750.

— Total Capital Adequacy Directive(CAD)13 charge decreases by $792,000(79.84 per cent) from $992,000 to$200,000.

— The RORAC14 increases by 342.95 percent from 16.28 per cent to 72.10 percent.

Compared with case 2 (classic repo wherethe CDS is used but not integrated withrepo), HedgeRepo is also quite beneficial.

— Profits increase by $25,000 (20.7 percent) from $119,205 to $144,205.

— Repo interest expense decreases by$13,750 (23.4 per cent) from $58,750 to$45,000.

— The cost of funds for haircut decreasesby $11,250 (75 per cent) from $15,000to $3,750.

— The total CAD charge decreases by$24,000 (10.71 per cent) from $224,000to $200,000.

— The RORAC improves by 35.49 percent from 53.22 per cent to 72.10 percent.

Similar arguments could be made for areverse repo deal in which the client has ashort position in a bond and a short positionin a CDS. In the case of a reverse repo of abond trading on special, however, the reporate in HedgeRepo may not improve,though haircut savings and improvement inRORAC could still be achieved.


$82,500 or 17.59 per cent on profit andloss (P&L).

— The borrower’s RORAC improves by33.33 per cent.

Also note that properly structuredderivatives, by managing risk, furtherreduce regulatory capital requirements forrepo participants. In the above twoparticular cases, on the entire $50m repocash loan, the regulatory CAD charge isreduced by $4.04m (79.91 per cent) and$136,000 (11.81 per cent), respectively,for the cash borrower. It should not beforgotten, however, that there are otherqualitative benefits offered by aHedgeRepo deal that uses a combinationof bond and CDS as collateral. Theseand others have been described in aprevious section.

To be conservative, the authors havehedged the portfolio with five CDSs, eachtied to a single particular bond. A moreeconomical hedge could be accomplishedusing a ‘first to default CDS’, which wouldprotect the portfolio against the first todefault bond of the collateral. Such a CDSwill be a lot cheaper than buying fiveseparate CDSs as the authors have done. Itwill not protect the lender againstsimultaneous defaults of more than onebond, however.

The point to be noted here is that thederivative markets could provide manydifferent solutions and are quite flexible,even in a repo context.

Applications of HedgeRepo

Market participants who are in either case1 or case 2 category (Table 1) could switch

Basket repo

Next, a similar analysis is performed on theportfolio shown in Table 2. The portfolio isa mix of a variety of high yield bonds fromcorporate sector, emerging markets andhome loan mortgage areas. The issuers areBrazil, Russia, Ford, GM, AccreditedMortgage Loan Trust (MBS bond) withvarying repo rates. The total market valueof the high yield bond portfolio is $61mand the nominal value is $55m. The tradeinvolves repo of a high yield bond portfolioby a BBB rated borrower for a cash loan of$50m. The lender of cash is AA rated. Therepo term is for three months. Theportfolio is hedged with CDSs on theindividual bonds. Each CDS is based on anotional $10m. These and other details ofthe repo deal are shown in Table 4.

Compared with the classic repo with nohedge, HedgeRepo produces the followingbenefits.

— The borrower is now able to insure the$61m junk bond portfolio for creditdefault risk.

— Though the insurance costs an additional$345,410, it only reduces the total profitby $262,910 (or 32.28 per cent less)because of the repo interest savings andreduction in haircut cost of capital inHedgeRepo.

— The borrower is also able to increasethe RORAC by 236.99 per cent.

Compared with classic repo with alreadyhedged collateral, HedgeRepo produces thefollowing benefits.

— The borrower’s profits increase by


to HedgeRepo (case 3) and benefit asshown above. The possible list ofbeneficiaries for each category follows.

— Benefit by switching from classic repo toHedgeRepo: Market participants in thiscategory include those who have aposition in the cash market, and whoneed to use the repo market, but do notcurrently have a position in thederivative market. They might bemotivated to initiate a derivativeposition for better terms offered via theHedgeRepo, as illustrated in the aboveexample. The following are suchbeneficiaries:(1) Arbitrageurs, who can now trade

between repo and derivative marketsin new and different ways. Repotrading would be based on costdifferences in repo counterparty riskmanagement via traditional methodsversus derivative methods. If theCDS is cheap, but the repo rate andhaircuts are relatively quite high,then including the CDS as repocollateral will not only reduce costsbut may even generate a risk-freeprofit. For example, using classicrepo, a repo dealer doing businesswith a low rated counterparty couldaccept junk bond as collateral at ahigh haircut and lend cash at a highrepo rate. The dealer could thenturn around and use HedgeRepo toraise cash at a lower repo rate byusing the (junk bond � long CDS)as collateral.

(2) There might be some situationswhere reducing financing costs is a

priority for the repo counterparty.So, even though risk management isnot a priority, one could includeCDS as collateral just to qualify fora better repo rate and lower haircut.Instead of paying for a high haircutcost of capital, why not pay for thederivative-based hedge, especially ifit does not cost much more?

(3) Lower-rated credit parties withlower-rated assets who could nototherwise access repo financing.They could now qualify by using ahedge as additional repo collateral.

— Benefit by switching from already hedgedcollateral to HedgeRepo: Marketparticipants who have positions in boththe cash and derivative instrumentswould benefit from HedgeRepo. Thefollowing are such beneficiaries:(1) Cash-CDS basis traders who use the

repo market could further benefitfrom HedgeRepo, eg negative basistraders purchase the bond and theCDS. The bond is financed via theHedgeRepo using bond � CDS ascollateral, and the trade is beneficial,as illustrated in the above numericalexample. Likewise, positive basistraders short the bond and sell theCDS. The short bond is reversed invia HedgeRepo using (cash � shortposition in CDS) as packagedcollateral.

(2) CDS dealers who hedge theirderivative positions via the underlyingcash markets (eg high yield corporatebond) and also use the repo marketfor financing or borrowing cashinstruments. The dealers could use


(4) A constant maturity CDS (CMCDS) —this is a relatively new instrument inthe credit markets and offers investorsaccess to floating credit spreads. WithCMCDS, the premium changes as thespread moves. It would be useful forclassic repo participants who switch toHedgeRepo by purchasing a hedge.They could purchase a CMCDS insteadof a standard CDS and reduce theirexposure to CDS price volatility. Thiswould be especially useful if they holdthe underlying bond in a‘non-mark-to-market’ book (eg bankingbook).

(5) Options on CDS — these derivativeinstruments function in a mannersimilar to interest rate or currencyoptions. In a European-style option, theholder has the right to buy or sellprotection (CDS) on a specifiedreference entity for a predeterminedperiod, typically five years. Theseinstruments have grown in popularityrecently.

(6) Straight vanilla options on a bond,equity or other asset — these are themost straightforward derivativeinstruments to use for repo collateralpurposes.

CONCLUSION

HedgeRepo is an extension of thetraditional repo instrument. It enablesmultiple types of derivative instruments tobe used as repo collateral, while stillretaining all the safety features of traditionalrepo. The scope of the HedgeRepo issignificant, considering the growth rates in

the derivative positions as repocollateral. Likewise, cash marketdealers (eg bond/equity dealers) whofinance/borrow their cash positions inthe repo market, and also hedge theircash positions via the derivativemarkets, can use the derivativepositions as repo collateral.

(3) Hedgers (eg asset managers ofbond/equity portfolios) who usederivatives to hedge the risks and alsofinance/borrow the assets using therepo market. Integrated derivativerisk management reduces financingcosts for this group of participants.

Choice of hedging instruments

Within the ‘credit markets’, several hedginginstruments1 can be considered.

(1) A CDS — as described above, thisinstrument protects against default risk.Five-year CDSs are the most liquidcredit derivatives.

(2) A total return swap (TRS) — thisderivative instrument provides thecounterparty with the total return ofthe instrument. It is well known thatthe cash flows of a TRS closely mimicthe cash flows of a repo trade. Themain difference is that a CDS protectsonly against credit risk, while a TRSmitigates exposure to both market andcredit risks.

(3) A first to default swap (FtD CDS) —this derivative instrument wouldprovide protection against the first bondto default in a portfolio of risky bonds.It would be useful in a basketHedgeRepo of risky bonds.


derivative and repo markets and the recenttrends in repo, high yield bond and creditderivative markets. These trends include theuse of risky securities as repo collateral,coupled with an increasing focus on riskmanagement to drive the returns oninvestments and trading. Additionally, thehigh yield bond and credit derivativemarkets are growing rapidly across variousregions of the world (Europe and Asia).Risky counterparties, such as hedge funds,are increasingly using repo. The marketpenetration of repo in risky securities (eghigh yield bonds or equities), however, isquite low compared with the repo marketin ‘safe’ securities (eg government securitiesor highly rated corporate bonds) because ofthe inefficiencies of the classic repo inhandling non traditional collateral.HedgeRepo would make growth in repomarkets for risky securities possible byattracting new participants and new types ofcollateral. It reduces costs in repo forborrowers and increases the repo andderivative business volumes for repoproviders and increases the variety ofcounterparties and collateral flexibilitywithout increasing risk for repo lenders.

Additionally, integrated derivative-basedhedging of repo collateral transfers thecollateral and counterparty risks fromparticipants in the repo markets to thederivative markets.

This paper has discussed the applicabilityof credit derivatives, specifically CDS inrepo deals. The scope of HedgeRepo,however, is not limited to CDS. Exchangetraded derivatives such as futures andoptions on equities, bonds and indices, andOTC derivatives such as interest rate swaps,

equity index swaps, swaptions, caps/flooretc, could be used in combination withvarious underlying risky assets such asbonds, equities or portfolios of such assetsin HedgeRepo. For example, long positionsin equity put options or short position instock index futures or equity index swapscould be used to secure equity collateral ina repo.

HedgeRepo is most useful for riskyparticipants such as hedge funds, using openor term repo financing of risky securitieswhich inherently need to be hedged aswell. Typical users would be risky marketparticipants with a position in both the cashand derivative markets and who use therepo market for funding or borrowing thecash position. Examples of such participantsinclude hedge funds, bond, equity andderivative, dealers, traders and arbitrageurs,asset managers etc.

References

1 See Nelken, I. (1999) ‘Implementing CreditDerivatives’, McGraw Hill, New York, NY;Choudhry, M. (2004) ‘Structured CreditProducts’, John Wiley, Chichester, UK.

2 Choudhry, M. (2004) ‘Global Repo Markets:Instruments and Applications’, John Wiley,Chichester, UK.

3 Trade marked and patent pending — HedgeReposhall mean HedgeRepoTM.

4 See http://www.bankofny.com/pages/cibs_tripartyrepo.htm, accessed August 1, 2004.

5 BIS 74th Annual Report,http://www.bis.org/publ/ar2004e.htm, accessedAugust 1, 2004.

6 ISDA 2003 Year End Survey,http://www.isda.org, accessed August 1, 2004.

7 2003/2004 Credit Derivatives Report,http://www.bba.org.uk, accessed August 1, 2004.

8 Available from http://www.bondmarkets.com.9 ISMA Repo Market Surveys conducted in

December 2003 and June 2004,http://www.isma.org/surveys/repo.html.


largely based on Basel II.14 RORAC is return on risk-adjusted capital. In the

examples provided, it is computed as adjusted netincome vs regulatory capital charge as per BaselI. By considering RORAC, rather thanconventional accounting-based profit-and-losscalculations, it is possible to evaluate relativeperformances for minimising risk and maximisingreturn. RORAC provides a way of quantifyingand comparing returns from more and less riskybusiness ventures. Unlike VAR and other marketrisk measures, RORAC allows market risk, creditrisk and operational risk to be incorporated in asingle comprehensive risk measurementmethodology.

15 The authors have used an approximate repo ratefor general collateral hedged with creditderivatives in HedgeRepo. The repo rate,however, could also be calculated in a moreprecise way, using a quantitative approach. Forbonds that are on special, the repo rate has notbeen changed in HedgeRepo.

10 Evans, S. (2004) ‘Giving Credit Where It IsDue’, ISF Magazine, March,http://www.isfmagazine.com.

11 Eden, J. (2004) ‘How Synthetic Broking Becamethe Real Deal’, ISF Magazine, December,http://www.isfmagazine.com.

12 All examples, except for the ACCR bond, usemarket rates obtained by the authors on 26thAugust, 2004. For the ACCR bond, the marketdata were as of 6th October, 2004. CDS priceswere obtained from Bloomberg, and repo rateswere provided by ICAP.

13 The Capital Adequacy Directive (CAD) is anagreement on regulatory capital standards forfinancial intermediaries doing business in theEuropean Union (EU). The CAD takes a‘building block’ approach, requiring banks andsecurities houses to put up capital to cover themarket risk with respect to their trading book:position risk, counterparty/settlement risk, interestrisk and foreign exchange risk. The next versionof CAD will be known as CAD III and will be


The ‘HedgeRepo’ concept: Using credit derivatives as repo collateral

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