Question

Suppose Salami Brothers engages in a repo with a bank. In the agreement, Salami Brothers sells $9 987 950 worth of money-market securities to the bank and agrees to repurchase the securities in 30 days for $10 000 000. (20 Marks).

(a) Is this transaction a loan, and if so, who is the borrower and who is the lender? Defend your answer. ().

(b) Is the loan collateralised? What is the collateral? Who holds the collateral during the term of the agreement? ().

(c) What interest rate (or yield) is earned by the lender? ().

(d) Draw T-accounts for this transaction. Show the assets and liabilities for each party before and after the transaction. ().

Answer 1

a. Yes, this transaction is a loan where Salami Brothers is the borrower and the bank is the lender. Salami brothers sell money-market securities to the bank in exchange for money with the promise to repurchase it back in 30 days at a higher amount. Here, the money market securities in the collateral. The amount for which Salami brothers sell the securities in the loan principal amount and the amount for which they repurchase the securities is repayment of the principal plus an interest for the 30 day period. Such an agreement is called a Repo.

b. Yes, the loan is collateralised with the money market securities sold by Salami Brothers to the bank. During the period of the loan, collateral is held by the bank.

c. Total interest ($) = $10,000,000 - $9,987,950 = $12,050

Total interest rate for 30 days = $12050 / $9,987,950 = 0.1206%

Annual interest rate = 0.1206% * 360 / 30 = 1.447%