1. A dealer needs to borrow EUR 30 million. He uses a Bund as collateral. The Bund has the following characteristics:
• Start date: September 10
(a) How much collateral does the dealer need?
(b) Two days after the start of the repo, the value of the Bund increases to 101. How much of the securities will be transferred to whom?
(c) What repo interest will be paid?
2. A dealer repos $10 million T-bills. The haircut is 5%. The parameters of the deal are as follows:
(a) How much cash does the dealer receive?
(b) How much interest will be paid at the end of the repo deal?
3. A treasurer in Europe would like to borrow USD for 3 months. But instead of an outright loan, the treasurer decides to use the repo market. The company has holdings of Euro 40 million bonds. The treasurer uses a cross-currency repo. The details of the transaction are as follows:
• Term: September 1 to December 1
• Last coupon date on the bond: August 12
• Bond coupon 4% item EUR/USD exchange rate: 1.1150
(a) What is the invoice price (dirty price) of the bond in question?
(b) Should the repo be done on the dirty price or the clean price?
(c) How much in dollars is received on September 1?
(d) How much repo interest is paid on December 1?
CASE STUDY: CTD and Repo Arbitrage
Two readings follow. Please read them carefully and answer the questions that follow. You may have to first review three basic concepts: (1) special repo versus general collateral, (2) the notion of cheapest-to-deliver bonds, and (3) failure to deliver. You must understand these well, otherwise the following strategies will not make sense.
DB Bank is believed to have pocketed over EUR100 million (USD89.4 million) after reportedly squeezing repo traders in a massive interest-rate futures position. The bank was able to take advantage of illiquidity in the cheapest-to-deliver bond that would have been used to settle a long futures position it entered, in a move that drew sharp criticism from some City rivals.
In the trade, the Bank entered a calendar spread in which it went long the Eurex-listed BOBL March '01 future on German medium-term government bonds and sold the June '01 contract to offset the long position, said traders familiar with the transaction. One trader estimated the Bank had bought 145,000 March '01 contracts and sold the same number of June '01 futures. At the same time the Bank built up a massive long position via the repo market in the cheapest-to-deliver bond to settle the March future, in this case a 10-year Bund maturing in October 2005.
Since the size of the '05 Bund issue is a paltry EUR10.2 billion, players short the March future would have needed to round up 82% of the outstanding bonds to deliver against their futures obligations. "It is almost inconceivable that this many of the Bunds can be delivered," said a director-derivatives strategy in London. "Typically traders would be able to rustle up no more than 25% of a cheapest-to-deliver bond issue," he added.
At the same time it was building the futures position, the Bank borrowed the cheapest-to-deliver bonds in size via the repo market. Several traders claim the Bank failed to return the bonds to repo players by the agreed term, forcing players short the March future to deliver more expensive bonds or else buy back the now more expensive future.
The Bank was able to do this because penalties for failure to deliver in the repo market are less onerous than those governing failure to deliver on a future for physical delivery. Under Eurex rules, traders that fail to deliver on a future must pay 40 basis points of the face value of the bond per day. After a week the exchange is entitled to buy any eligible bond on behalf of the party with the long futures position and send the bill to the player with the short futures position, according to traders. Conversely, the equivalent penalty for failure to deliver in the repo market is 1.33 bps per day (IFR, March 2001).
Eurex is introducing position limits for its September contracts in its two, five, and 10-year German government bond futures. "If we want, we will do it in December as well," said a spokesman for the exchange.
The move is aimed at supporting the early transfer of open positions to the next trading cycle and is a reaction to the successful squeeze of its Bundesobligation (Bobl) or five-year German government bond futures contract in March.
"The new trading rules limit the long positions held by market participants, covering proprietary and customer trading positions," said Eurex's spokesman. Position limits will be set in relation to the issue size of the cheapest-to-deliver bond and will be published six exchange trading days before the rollover period begins (IFR, June 9, 2001).
Part A. First Reading
1. What is a calendar spread? Show DB's position using cash flow diagrams.
2. Put this together with DB's position in the repo market.
3. What is DB's position aiming for?
4. What is the importance of the size of '05 Bund issue? How do traders "rustle up" such bonds to be delivered?
5. Why are penalties for failure to deliver relevant?
6. Would an asset swap (e.g., swapping Libor against the relevant bond mentioned in the paper) have helped the shorts? Explain.
7. Could taking a carefully chosen position in the relevant maturity FRA, offset the losses that shorts have suffered? Explain carefully.
8. Explain how cheapest-to-deliver (CTD) bonds are determined. For needed information go to Web sites of futures exchanges.
Part B. Second Reading
1. Eurex has made some changes in the Bund futures trading rules. What are these?
2. Suppose these rules had been in effect during March, would they have prevented DB's arbitrage position?
3. Would there be ways DB can still take such a position? What are they?
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