Hedge funds have traditionally used repo agreements to short securities and gain short-term exposure to illiquid assets but increasingly are starting to use total rate of return swaps instead. Frederik Barnekow, head of securities finance at SEB Merchant Bank in Stockholm, attributes this to the growing sophistication of hedge funds. Stuart Pyott, equity derivatives trader at Schroder Salomon Smith Barney in London, added that the demand for swaps has grown over the last year because they have become more liquid, standardized and competitively priced.
What Are Total Return Swaps And Repos?
A total rate of return swap allows an entity, such as a hedge fund, to receive the change in market value of a security--plus any dividend or coupon--in return for paying a floating interest-rate. The result is the hedge fund is synthetically long the asset in exchange for an interest-rate charge rather than having to fund an outright purchase in the cash market.
The counterparty to the trade has likely hedged its position by buying the underlying and therefore holds no economic risk.
Repo is an abbreviation of Sale and Repurchase Agreement. Demand typically comes from hedge funds that own stock but want to lend it out in order to free up funds to finance positions. The fund would sell the security to a prime broker with an agreement to buy it back at a future date at the initial market price plus a premium. This strategy does not entail a directional market view.
Alternatively if the hedge fund thinks the security is going to fall in value it can borrow the security from the prime broker or enter a reverse repo, in which the fund would have to post collateral with the prime broker as a guarantee and to reduce the lending rate, and then sell it short, according to Will Cutts, director in equity finance at Schroder Salomon Smith Barney in London.
Dan Kaiser, managing director in credit derivatives marketing at Bear Stearns in New York, said repos tend to be used for short-term financing on liquid securities but total-return swaps are used for longer periods and are often used for leveraging positions and gaining exposure to illiquid assets. The largest repo market is the overnight market and although players often roll over the contracts daily it is not considered a long-term measure.
The minimum maturity of a total-return swap is more like six months and they can go out to five years or more, according to Kaiser. Repos are more popular for short maturities because they are cheaper to put on than their synthetic equivalents. Repos are often on highly liquid stocks as the contracts require constant mark-to-market valuations and one of the counterparties must own the stock. In the swap, payments can be made less frequently and neither counterparty needs to hold the stock, although the party with the economic exposure may want to hedge its position. This means total-return swaps on illiquid assets are more expensive than on liquid assets.
Leveraging the position is theoretically possible with both contacts but it occurs more often in the credit derivatives market. Schroder Salomon Smith Barney's Pyott added that hedge funds also use contracts for differences to leverage their positions. He explained that economically these are similar to total-return swaps but the purchaser pays a margin up-front rather than a swap rate.
A hedge fund looking to take a leveraged long position in agency bonds might, for example, repo USD100 million of agencies and use the proceeds to finance other trades. But "The hedge fund is still on the hook for USD100 million," Kaiser explained. In a limited recourse total-return swap the hedge fund can take on USD100 million of exposure with only USD25 million of capital. If disaster strikes and the bonds plummet the hedge fund is only down USD25 million and the swap counterparty has to pay the rest.
Schroder Salomon Smith Barney's Cutts said repos are less expensive than total-return swaps because they are a more mature and liquid product. For example the firm would charge a quoted regulated investment fund--rated single A by Standard & Poor's--LIBOR plus eight basis points for a one-month repo agreement on DaimlerChrysler shares, whereas a total rate of return swap with the same maturity would cost LIBOR plus 18bps. Cutts attributes the extra cost to the charge for using the firm's balance sheet and setting up a bespoke contract.
The Legal Framework
The most significant legal difference between a repo and a total-return swap is the assets are physically transferred in a repo, according to Claude Brown, partner at Clifford Chance in London. Transferring the ownership of the underlying can cause problems as some assets are not readily transferable, there are usually costs involved and there may be problems with liquidity. Brown said, the disadvantage of not transferring the physical assets is the hedge fund has all the economic risk without necessarily any of the legal advantages of holding the asset. The most common example of this is not having voting rights.
Banks have to put less regulatory capital behind repo positions than total-return swaps under the current European Union capital adequacy rules, but this is due to change and should boost the total-return swap market. Under the existing regime any financial product can be put in a repo and the bank will receive regulatory capital relief. But, Brown added, this is likely to change in line when the new Basel Capital Adequacy Accord is adopted in 2005. The new accord will split repo agreements into Organisation for Economic Co-Operation and Development sovereign and non-OECD sovereign. Repos on government securities will continue to get 100% regulatory relief, but others will be treated as collateralized loans and will receive less regulatory relief.
However Browne said there are still some legal obstacles to total-return swaps taking off. The most significant is that a swap is categorized as a derivatives contract whereas a repo is a purchase and sale of securities. Many institutions, such as pension funds in the U.K., can only use derivatives for efficient portfolio management rather than investment.
This week's Learning Curve was written by Jeremy Carter, managing editor for Derivatives Week in London.