Financial Risk Manager Part 2

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Consider a scenario where a bank is participating in a repurchase agreement (repo) transaction involving a bond that has a notional value of 100,000 USD. This bond pays a semi-annual coupon rate of 6% and is currently priced at 97 USD in the market. The terms of the repo transaction include a repo haircut of 10% and a repo interest rate of 4%. The duration of the repo agreement is set to terminate in 6 months. Calculate the bank's anticipated cash outflow at the end of the repo transaction.

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Explanation:

B is correct. Cash inflow at beginning of repo: (100,000)(97%+6%0.25)(1-10%) = 88,650; Cash outflow at end of repo: 88,650(1+4%*0.5)=90,423

The bank initially buys a bond with a notional value of $100,000 at a price of$ 97 (which is 97% of the notional value). The bond has a semi-annual coupon of 6%, and the bank is buying it on the coupon payment date. Therefore, the bank is entitled to receive an accrued interest of 6% * 0.25 (since it's three months into the six-month period) on the notional value.

When the bank decides to repo the bond, it receives an initial cash inflow, which is calculated as follows:

The bond price is adjusted for the accrued interest: $100,000 * (97% + 6% * 0.25) =$ 97,500
The repo haircut of 10% is applied: $97,500 * (1 - 10%) =$ 88,650

The repo contract has a term of 6 months, and the repo interest rate is 4%. The bank needs to calculate the cash outflow at the end of the repo transaction, which includes the return of the principal and the interest accrued during the repo period.

The cash outflow at the end of the repo is calculated as follows:

The principal amount is $88,650
The interest accrued for three months (half of the six-month repo term) at a rate of 4% is: $88,650 * 4% * 0.5 =$ 1,768
The total cash outflow is: $88,650 +$ 1,768 = $90,423

Therefore, the bank's expected cash outflow at the end of the repo transaction is $90,423, which corresponds to option B.