204 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
Figure 5.10:A Bank betraying its Pawnshop RootsSourceAuthor’s picture
Example 5.30
In a repurchase order (repo) or repurchase agreement, an investor in need of short-
term financing sells low-risk assets (like T-bills) to a lender, and buys them back
under a short-term forward contract. This is another example of a swap contract (a
spot sale reversed in the forward market). In terms of cash flows, this is equivalent
to taking out a secured loan. Because of the virtual absence of risk, the interest rate
implicit between the spot and forward price is lower than an ordinary offer rate and
differs from the lending rate by a very small spread, called the bank’s “haircut.” In
the case of default, the bank’s situation is quite comfortable because it is already
legally the owner of the T-bills.
Repo lending is a fancy name for what is done in pawnshops. In fact, banking
and pawning used to be one and the same. In Germany, a repo is called aLombard
(and the repo rate is called the Lombard rate), after the North-Italian bankers that
introduced such lending in the Renaissance times; in Dutch,lommerdjust means
Pawnshop. The Catholic Church, incensed at the high rates charged, then started
its own Lombard houses with more reasonable rates. These institutions were often
calledMons Pietatis, Mount(ain) of Mercy; some still exist nowadays and a few
have grown into big modern banks. The oldest surviving bank, Monte dei Paschi de
Siena (1472), is one of these. Figure 5.10 shows a Spanish example.
We know, from Chapter 2, that central banks can steer the money supply upward
by lending money to commercial banks, or downward by refusing to roll over old
loans to banks. Nowadays these loans typically take the form of repo’s. In many
countries the repo rate has become the main beacon for short-term interest rates.
In short, simplicity and efficiency is one advantage of a swap contract over a
secured or back-to-back loan. To lawyers, who do not necessarily view simplicity as
a plus, the main attractions are that the words security, interest, and loan/deposit