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What Is an Implied Repo Rate (IRR)?
The implied repo rate (IRR) is the rate of return that bond futures or forward contract traders earn when they buy the underlying asset and deliver it when the contract settles. Traders typically buy the actual bond or issue of an equal amount in the cash market using borrowed money. It is held until it is delivered into the futures or forward contract and the loan is repaid.
Key Takeaways
- An implied repo rate is the rate of return that can be earned by owning a bond and simultaneously shorting a futures or forward contract against it.
- This strategy functions much like a repurchase agreement, in that the bond that the bond that is owned will be taken back when the short futures contract expires.
- The net return or repo rate tends to be close to the risk-free rate as the buying and selling involved amount to arbitrage.
Understanding Implied Repo Rates (IRRs)
A repo refers to the repurchase agreements that function as a form of a collateralized loan. It is executed by arranging to buy and subsequently sell a particular security at a specified time for a predetermined amount, A dealer generally borrows funds less than a particular bond's value from a customer while the bond functions as collateral. Since the amount borrowed is less than the value of the bond, the lending customer has a reduced level of risk if the value of the bond decreases before the repayment time is reached.
The implied repo rate refers to the return that a trader earns (and calculated as net profit) from the processing of selling a bond futures contract or other issue. This subsequently uses the borrowed funds to buy a bond of the same value with delivery taking place on the associated settlement date. The IRR comes from the reverse repo market, which has similar gain/loss variables as the implied repo rate, and provides a function similar to that of a traditional interest rate.
All types of futures and forward contracts have an IRR—not just bond contracts. For example, the price at which wheat can be simultaneously purchased in the cash market and sold in the futures market, minus storage, delivery, and borrowing costs, is an implied repo rate. In the mortgage-backed securities TBA market, the implied repo rate is known as the dollar roll arbitrage.
The implied repo rate is considered to be a theoretical yield.
Implied Repo Rates (IRRs) and Settlement Dates
The terms regarding when the repayment of the loan is required are referred to as the settlement date. These terms can vary. In many instances, the funds are only held by the borrower overnight, which causes the transaction to settle within one business day. Longer terms can be made available, though the majority remain under 14 days in length.
In transactions between money market funds and hedge funds, a bank may participate as a form of middleman. This allows the money market funds, which are supported by cash, and hedge funds, which are traditionally supported by bonds, to move funds smoothly between entities.
The market upon which these transactions take place is referred to as the repo market. After the financial crisis of 2008, the size of the repo market saw a reduction, spurred by the bank industry's reluctance to lend Treasuries. This, in turn, made it more challenging for investors in the repo market to find interested borrowers looking for cash.
What Is a Bond Future?
A bond future is a financial contract that obligates the contract holder to buy or sell the underlying bond at a predetermined price by a certain date. This date is referred to as the maturity date. Although the contract can be held until the bond's maturity date, it can be closed earlier. This may result in a profit or loss. Bond futures are traded through the futures exchange market.
What Is a Rate of Return?
The term rate of return refers to the net loss or gain an investor earns on an investor over a certain period. The RoR is commonly expressed as a percentage of the investment's original price or cost. A rate of return can be applied to any type of investment, including stocks, bonds, ETFs, mutual funds, and real estate, as well as non-traditional investments like art, jewelry, and furniture.
What Are Settlement Periods for Financial Transactions?
Most financial transactions typically settle within one business day after they are initiated. This is referred to as a T+1 settlement. If a transaction is initiated on a Tuesday, the transaction settles the following business day. If it is initiated on a weekend or holiday, it settles the day after the next business day.
The Securities and Exchange Commission (SEC) shortened the settlement period from T+2 to T+1 for trades initiated by banks, broker-dealers, and other institutional traders in 2023. The changes went into effect in May 2024.
The Bottom Line
The rate of return is what an investor earns (or loses) on an investment. The rate of return that investors who deal with futures or forward contracts earn is called the implied repo rate. This rate is earned when an investor owns a bond or other asset and shorts their futures or forward contract against it.
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