In practice, “repricing” a transaction (whether that transaction is a Repurchase Transaction or a Buy/Sell Back Transaction) is an alternative to making a traditional margin call for a party with either “Transaction Exposure” (with respect to a single transaction) or “Net Exposure” (with respect to multiple transactions). In practice, this method tends to be used more frequently in relation to Buy/Sell-Backs.
At a high level, “repricing” a transaction involves the termination of the transaction to be “repriced” and its replacement with a new transaction. The Purchase Price of the new transaction will be based on the then current value of the securities which have been provided as ‘collateral’. In essence, the exposure is eliminated by keeping the securities side of the transaction the same, but adjusting the cash side of the transaction up or down as necessary. This will result in either (a) cash being returned to the Buyer (if the value of the securities has fallen and so can no longer support the previous level of ‘lending’), or (b) a top-up of cash being paid to the Buyer (if the value of the securities has increased and can support a greater level of ‘lending’ than was previously the case).
More specifically, any repricing would be effected as follows:
Firstly, the “Repurchase Date” under the relevant transaction (which is known for these purposes as the “Original Transaction”) is deemed to occur on the date on which the repricing is to be effected (this is known as the “Repricing Date”). The effect of this is to effectively bring forward the maturity date of the trade to be repriced. In turn, this would accelerate the need for the Seller to return the ‘loan plus interest’ and the Buyer to return the ‘collateral’. In effect, this would bring the Original Transaction to an end (and, as we will see, bring into existence a new trade with the same underlying securities – just at a different price).
Next, on the date which is the “Repurchase Date” under the “Original Transaction”, the parties are deemed to have entered into a new transaction (this is known as the “Repriced Transaction”). The Purchased Securities under the Repriced Transaction are to be regarded as Securities equivalent to the Purchased Securities under the Original Transaction. So, in effect, the parties are swapping the securities which underpinned the “Original Transaction” and using them for the purposes of the “Repriced Transaction”.
Next, the “Purchase Date” under the Repriced Transaction will be the “Repricing Date”. In other words, the date on which the parties reprice the transaction is taken as the ‘start date’ of the Repriced Transaction (in other words, the date on which the “Purchased Securities” are actually purchased);
Next, the “Purchase Price” under the Repriced Transaction will equal the Market Value of the Securities on the Repricing Date divided by the Margin Ratio applicable to the Original Transaction. i.e.
In simple terms, the parties to the “Repriced Transaction” are reverse-engineering the amount of the ‘loan’ that can be made in order that it fits fit the then current market value of the securities which are available to be used as ‘collateral’ (of course, factoring in the ‘initial margin buffer’ that is required).
Next, the other terms of the Repriced Transaction will be the same as those of the Original Transaction – the Repurchase Date, the Pricing Rate and the Margin Ratio are specifically mentioned as being the same as those under the Original Transaction. In other words, the following will all stay the same:
- The maturity date of the “Repriced Transaction” (i.e. the “Repurchase Date”);
- The ‘interest’ being charged under the ‘loan’ (i.e. the “Pricing Rate”); and
- The ‘collateral cushion’ (in other words, the value of the underlying securities as a proportion of the money that the Buyer is prepared to ‘lend’ i.e. the “Margin Ratio”).
Finally, the obligations of the parties with respect to the delivery of the Purchased Securities (an obligation of the Seller) and the payment of the Purchase Price (an obligation of the Buyer) under the Repriced Transaction will be set off against the obligations of those same parties to pay the Repurchase Price (an obligation of the Seller) and to deliver Equivalent Securities (an obligation of the Buyer) under the Original Transaction with the result that only a net balancing cash sum will be paid by one party to the other.
Taking a step back, hopefully it is possible to see that the parties are not physically unravelling the entirety of “Original Transaction” and then putting in place the “Repriced Transaction”. Rather, they are basically just ‘rolling’ the “Original Transaction” into the “Repriced Transaction”. It is worth noting that no Margin Transfers take place. Instead, the cash leg of the transaction is effectively adjusted in order to make it fit the new value of the securities posted as collateral.
It is worth re-emphasising the fact that – when a transaction is repriced – the cash leg of the transaction is amended to make it fit the value of the securities. In contrast, when a transaction is adjusted, the securities leg of the transaction is amended in order to make it fit the amount of available cash.
Let’s examine how repricing of transactions works in practice as a risk management tool. This example is deliberately simplified in order to draw focus to the repricing mechanism. As such, for these purposes, we will ignore the fact that the “Repurchase Price” increases over time (in other words, that interest accrues on the ‘loan’). In addition, we will consider just one trade – remembering that, in practice, exposure is calculated across the entire portfolio rather than just one transaction. In reality, more than one transaction within the portfolio may be repriced in order to eliminate exposure (usually starting with the transaction with the highest exposure and working downwards from there).
Consider the following basic scenario:
- The Seller wants to ‘borrow’ GBP 100. This would be the “Purchase Price”.
- The Buyer is happy to ‘lend’ GBP 100 provided that it receives GBP 104 worth of collateral.
We have seen previously that the “Margin Ratio” of a transaction is equal to the “Market Value” of the Purchased Securities at the time when the Transaction was entered into divided by the Purchase Price. In other words, the “Margin Ratio” is:
So, in this case, the Margin Ratio for this particular transaction would be 104/100 = 1.04.
Imagine that 10 days later, the value of the securities has fallen to GBP 80. Instead of making a “Margin Transfer” in order to extinguish the “Transaction Exposure” that has arisen, it is possible to reprice the transaction instead. In order to achieve this, the “Original Transaction” would be terminated on day 10 and a new transaction would be executed on the same day on exactly the same terms, bar the fact that it is necessary to adjust the “Purchase Price” (in other words, adjust the amount that the Buyer is ‘willing to lend’) to reflect the fact that the market value of the underlying securities (in other words, the value of the ‘collateral’) has fallen in value.
By exactly how much should the “Purchase Price” be adjusted (in other words, exactly how much would the Buyer be willing to ‘lend’) in these circumstances?
In answering this question, hopefully you remember that the “Purchase Price” under the Repriced Transaction (in other words, the amount which the Buyer is willing to ‘lend’), is equal to the Market Value of the Securities on the Repricing Date divided by the Margin Ratio applicable to the Original Transaction. In other words, it is equal to:
Substituting in a few numbers we see that the “Purchase Price” is equal to
So, effectively, the Buyer is now willing to lend only GBP 76.92 against collateral currently valued at £80. Intuitively, this feels right. With GBP 80 of ‘collateral’ against GBP 76.92 of ‘lending’, the Buyer is over-collateralised and so is protected against the market risk inherent in taking securities as collateral. More specifically, the Buyer’s buffer of collateral is (proportionately) the same as it was under the Original Transaction.
On this basis, the Seller would have to return GBP 100 – GBP 76.92 = GBP 23.08 to the Buyer in order to bring down the level of exposure. In reality, it would be slightly more than this as more than GBP 100 would then be outstanding (due to the accrual of interest) – but we have already said that, for simplicity’s sake, we will ignore that factor.Contact Us