Which of the following is most likely to explain a low repo rate on a repurchase agreement? A. The collateral has a low credit rating. B. The counterparty has a low credit rating. C. Delivery of the collateral to the lender is required.
The Correct Answer and Explanation is:
The most likely explanation for a low repo rate on a repurchase agreement is B. The counterparty has a low credit rating.
Explanation:
A repurchase agreement (repo) is a short-term loan where one party sells securities to another party with an agreement to repurchase them at a later date for a slightly higher price. The difference in price represents the interest or repo rate. The key factors influencing the repo rate include the quality of the collateral, the creditworthiness of the counterparty, and the structure of the transaction.
A. The collateral has a low credit rating:
While the quality of collateral is important, a repo with low-credit collateral usually demands a higher repo rate to compensate the lender for the increased risk of holding less secure assets. In general, if the collateral is riskier, the borrower must pay a higher interest rate to attract a lender, not a lower one. This would typically lead to a higher repo rate, not a lower one.
B. The counterparty has a low credit rating:
This is the most likely reason for a low repo rate. If the counterparty (the party borrowing the funds) has a low credit rating, the lender might require a lower rate as part of a competitive market environment or to take advantage of a short-term opportunity. In some cases, if the counterparty is highly reputable despite a low credit rating, the lender may not demand a high rate, especially if other market conditions are favorable (such as low interest rates). In short, the lower repo rate could reflect confidence in the ability of the counterparty to repay the loan despite a lower credit rating.
C. Delivery of the collateral to the lender is required:
Typically, the lender receives the collateral upfront in a repo agreement. If delivery is required, this is standard practice and does not directly influence whether the rate is low or high. If anything, requiring delivery of collateral may reduce risk, but it wouldn’t be the primary factor in determining a low repo rate.
Thus, B stands out as the most likely reason for a low repo rate in this context.
