Special Repo Rates:

An Introduction
MARK FISHER
The author is a senior economist in the financial section of the Atlanta
Fed’s research department. He thanks Jerry Dwyer, Scott Frame, and
Paula Tkac for their comments on an earlier version of the article
and Christian Gilles for many helpful discussions on the subject.

he market for repurchase agreements spread between the general collateral rate and the

T
involving Treasury securities (known as repo rate specific to the on-the-run security). Dealers
the repo market) plays a central role in sell short on-the-run Treasuries in order to hedge
the Federal Reserve’s implementation the interest rate risk in other securities. Having sold
of monetary policy. Transactions involv- short, the dealers must acquire the securities via
ing repurchase agreements (known as reverse repurchase agreements and deliver them to
repos and reverses) are used to manage the quan- the purchasers. Thus, an increase in hedging demand
tity of reserves in the banking system on a short- by dealers translates into an increase in the demand
term basis. By undertaking such transactions with to acquire the on-the-run security (that is, specific
primary dealers, the Fed, through the actions of collateral) in the repo market.
the open market desk at the Federal Reserve Bank The supply of specific collateral to the repo market
of New York, can temporarily increase or decrease is not perfectly elastic; consequently, as the demand
bank reserves. for the collateral increases, the repo rate falls to
The focus of this article, however, is not monetary induce additional supply and equilibrate the market.
policy but, rather, the repo market itself, especially The lower repo rate constitutes a rent (in the form of
the role the market plays in the financing and hedg- lower financing costs), which is capitalized into the
ing activities of primary dealers. The main goal of the value of the on-the-run security. The price of the
article is to provide a coherent explanation of the on-the-run security increases so that the equilibrium
close relation between the price premium that newly return is unchanged. The rent can be captured by
auctioned Treasury securities command and the reinvesting the borrowed funds at the higher general
special repo rates on those securities. The next two collateral repo rate, thereby earning a repo dividend.
paragraphs outline this relationship and introduce When an on-the-run security is first issued, all of the
some basic terminology that will be used throughout expected earnings from repo dividends are capital-
the article. (Also see the box for a glossary of terms.)1 ized into the security’s price, producing the liquidity
Dealers’ hedging activities create a link between premium. Over the course of the auction cycle, the
the repo market and the auction cycle for newly repo dividends are “paid” and the liquidity premium
issued (on-the-run) Treasury securities. In particular, declines; by the end of the cycle, when the security
there is a close relation between the liquidity pre- goes off-the-run (and the potential for additional repo
mium for an on-the-run security and the expected dividend earnings is substantially reduced), the pre-
future overnight repo spreads for that security (the mium has largely disappeared.

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 27

 BOX
Glossary

Announcement date: The date on which the Repo: A repurchase agreement transaction that
Treasury announces the particulars of a new secu- involves using a security as collateral for a loan.
rity to be auctioned. When-issued (that is, for- At the inception of the transaction, the dealer
ward) trading begins on the announcement date. lends the security and borrows funds. When the
transaction matures, the loan is repaid and the
Auction date: The date on which a security is auc- security is returned.
tioned, typically one week after the announcement
date and one week before the settlement date. Repo dividend: The repo spread times the value
of the security: δ = ps = p(r – R).
Fedwire: The electronic network used to trans-
fer funds and wirable securities such as Treasury Repo rate: The rate of interest to be paid on a
securities. repo loan, R.

Forward contract: A contract to deliver some- Repo spread: The difference between the gen-
thing in the future on the delivery date at a pre- eral collateral rate and the specific collateral rate,
specified price, the forward price. s = r – R, where s ≥ 0.

Forward premium: The difference between the Repo squeeze: A condition that occurs when the
expected future spot price and the forward price. holder of a substantial position in a bond finances
a portion directly in the repo market and the
Forward price: The agreed-upon price for deliv- remainder with “unfriendly financing” such as in
ery in a forward contract. a triparty repo.
General collateral: The broad class of Treasury Reverse: A repo from the perspective of the
securities. counterparty; a transaction that involves receiv-
ing a security as collateral for a loan.
General collateral rate: The repo rate on gen-
eral collateral. Settlement date: The date on which a new secu-
rity is issued (the issue date).
Haircut: Margin. For example, a 1 percent hair-
cut would allow one to borrow $99 per $100 of a Short squeeze: See repo squeeze.
bond’s price.
Specific collateral: Collateral that is specified—
Matched book: Paired repo and reverse trades for example, an on-the-run bond instead of some
on the same underlying collateral, perhaps mis- other bond.
matched in maturity.
Specific collateral rate: The repo rate on spe-
Off the run: A Treasury security that is no longer cific collateral.
on the run (see below).
Term repo: Any repo transaction with an initial
Old, old-old, etc.: When a security is no longer maturity longer than one business day.
on the run, it becomes the old security. When a
security is no longer the old security, it becomes Triparty repo: An arrangement for facilitating
the old-old security, and so on. an ongoing repo relationship between a dealer
and a customer, where the third party is a clear-
On special: The condition of a repo rate when it ing bank that provides useful services.
is below the general collateral rate (when R < r).
When-issued trading: Forward trading in a
On the run: The most recently issued Treasury security that has not yet been issued.
security of a given original term to maturity—for
example, the on-the-run ten-year Treasury note. Zero-coupon bond: A bond that makes a single
payment when it matures.
Reopening: A Treasury sale of an existing bond
that increases the amount outstanding.

28 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

 CHART 1
The next section describes what repos and
A Repo and a Reverse Repo
reverses are, describes the difference between on-
the-run and older securities, and discusses the
A Repo
ways dealers use repos to finance and hedge. The
collateral
article then explains the difference between gen-
At inception: Dealer Customer
eral and specific collateral, defines the repo spread funds
and dividend, presents a framework for determin-
ing the equilibrium repo spread, and describes the collateral
average pattern of overnight repo spreads over the At maturity: Dealer Customer
auction cycle. funds + interest
The central analytical point of the article is that
A repo (from the dealer’s perspective) finances the dealer’s
the rents that can be earned from special repo rates long position (collateralized borrowing).
are capitalized into the price of the underlying bond so
as to keep the equilibrium rate of return unchanged. A Reverse Repo
The analysis derives an expression for the price pre- collateral
mium in terms of expected future repo spreads and At inception: Dealer Customer
then computes the premium over the auction cycle funds
from the average pattern of overnight repo spreads.
Some implications of this analysis are then discussed. collateral
Finally, the article presents an analysis of a repo At maturity: Dealer Customer
squeeze, in which a repo trader with market power funds + interest
chooses the optimal mix of funding via a triparty repo A reverse repo (from the dealer’s perspective) finances the
and funding directly in the repo market. Two appen- dealer’s short position (collateralized lending).
dixes provide additional analysis on the term struc-
ture of repo spreads and on how repo rates affect the
computation of forward prices and tests of the expec- For concreteness, the discussion will refer to the
tations hypothesis. two counterparties as the dealer and the customer
even though a substantial fraction of repo transac-
Repos and Dealers tions are among dealers themselves or between

A repurchase agreement, or repo, can be thought

of as a collateralized loan. In this article, the
collateral will be Treasury securities (that is, Treasury
dealers and the Fed. Unless otherwise indicated, the
article will adopt the dealer’s perspective in charac-
terizing the transaction. Repo and reverse repo
bills, notes, and bonds).2 At the inception of the transactions are illustrated in Chart 1, which can be
agreement, the borrower turns over the collateral to summarized by a simple mantra that expresses what
the lender in exchange for funds. When the loan happens to the collateral at inception from the deal-
matures, the funds are returned to the lender along er’s perspective: “repo out, reverse in.”
with interest at the previously agreed-upon repo Since dealers are involved with customers on
rate, and the collateral is returned to the borrower. both sides of transactions, it is natural for dealers
Repo agreements can have any maturity, but most to play a purely intermediary role. Chart 2 depicts a
are for one business day, referred to as overnight. matched book transaction. In fact, the dealer may
From the perspective of the owner of the security mismatch the maturities of the two transactions, bor-
and the borrower of funds, the transaction is referred rowing funds short-term and lending them long-term
to as a repo while from the lender’s perspective the (that is, reversing in collateral for a week or a month
same transaction is referred to as a reverse repo, or from customer 1 and repoing it out overnight first to
simply a reverse. customer 2 and then perhaps to another customer).

1. A number of sources provide additional material for anyone interested in reading more about the repo market. To read about
how the repo market fits into monetary policy, see Federal Reserve Bank of New York (1998 and n.d.). For institutional
details, see Federal Reserve Bank of Richmond (1993) and Stigum (1989). For some empirical results, see Cornell and
Shapiro (1989), Jordan and Jordan (1997), Keane (1996), and Krishnamurthy (forthcoming). Duffie (1989) provides some
theory as well as some institutional details and empirical results.
2. There is also an active repo market for other securities that primary dealers make markets in, such as mortgage-backed secu-
rities and agency securities (issued by government-sponsored enterprises such as Freddie Mac, Fannie Mae, and the Federal
Home Loan Banks). In the equities markets, what is known as securities borrowing and lending plays a role analogous to the
role played by repo markets, and as such much of the analysis of repo markets presented here is applicable to equities.

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 29

 CHART 2
A Dealer’s Matched Book Transaction

collateral collateral
At inception: Customer 1 Dealer Customer 2
funds funds

collateral collateral
At maturity: Customer 1 Dealer Customer 2
funds + interest funds + interest

A dealer’s matched book transaction involves simultaneous offsetting repo and reverse transactions. From customer 1’s perspective the
transaction is a repo while from customer 2’s perspective the transaction is a reverse. The dealer collects a fee for the intermediation ser-
vice by keeping some of the interest that customer 1 pays.

CHART 3
Making a Market I

Told Told
Seller Dealer Purchaser
bid price ask price

A dealer purchases an old Treasury security (Told) and immediately finds a buyer, earning a bid-ask spread.

Typically, customer 1 is seeking financing for a example that follows illustrates what is involved in
leveraged position while customer 2 is seeking a financing and hedging a position that is generated
safe short-term investment. in making a market in Treasury securities.
On-the-run securities. The distinction between Suppose a dealer purchases from a customer an
on-the-run securities and older securities is impor- old (or older) Treasury security. The dealer may be
tant. For example, the Treasury typically issues a able to immediately resell the security at a slightly
new ten-year note every three months. The most higher price, thereby earning a bid-ask spread (see
recently issued ten-year Treasury security is Chart 3). On the other hand, since older Treasury
referred to as the on-the-run issue. Once the securities are less actively traded, the dealer may
Treasury issues another (newer) ten-year note, the have to wait some time before an appropriate pur-
previously issued note is referred to as the old ten- chaser arrives. In the meantime, the dealer must
year note. (And the one issued before that is the (1) raise the funds to pay the seller and (2) hedge
old-old note, etc.) Similar nomenclature applies to the security to reduce, if not eliminate, the risk of
other Treasury securities of a given original maturity, holding the security. The funds can be raised by
such as the three-year note and the thirty-year repoing out the security. An important way that
bond. Importantly, the on-the-run security is typi- dealers hedge such positions is by short selling an
cally more actively traded than the old security in on-the-run Treasury security with a similar matu-
that both the number of trades per day and the rity. The price of such an on-the-run security will
average size of trades are greater for the on-the-run tend to move up and down with the old security;
security. In this sense, the on-the-run security is consequently, if the price of the old security falls,
more liquid than the old security.3 generating a loss, the price of the on-the-run secu-
Financing and hedging. A dealer must finance, rity will also fall, generating an offsetting gain.
or fund, every long position and every short position Assuming the dealer does in fact sell the on-the-run
it maintains. For Treasury securities, this means security short, the dealer now has an additional
repoing out the long positions and reversing in the short position that generates cash (from the buyer)
short positions. In addition to financing, the dealer but requires delivery of the security. The dealer
must decide to what extent it will hedge the risk it uses the cash (from the short sale) to acquire the
is exposed to by those positions. For many posi- security as collateral in a reverse repurchase agree-
tions, if not most, the dealer will want to hedge ment, which is then delivered on the short sale (see
away all or most of its positions’ risk exposure. The Chart 4).

30 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

 CHART 4
Making a Market II
Outright purchase Repo
Told Told
Financing: Seller Dealer Customer
bid price funds

Outright sale Reverse

Tnew Tnew
Hedging: Customer Dealer Customer
funds funds

A dealer purchases an old Treasury from a seller but has no immediate buyer.

CHART 5
Making a Market III
New repo Unwind old repo
Told Told
Refinancing: Customer Dealer Customer
funds funds

New reverse Unwind old reverse

Tnew Tnew
Rehedging: Customer Dealer Customer
funds funds

If no purchaser arrives (the next day), the dealer refinances and rehedges.

CHART 6
Making a Market IV
Outright sale Unwind old repo
Told Told
Purchaser Dealer Customer
ask price funds

New reverse Unwind old reverse

Tnew Tnew
Customer Dealer Customer
funds funds

When a purchaser arrives, the dealer sells the old Treasury (to the purchaser) and buys the on-the-run Treasury to close the short position.

If a purchaser for the original security does not repo on the old Treasury, and purchases the on-the-
arrive the next day, the dealer will repo the security run Treasury outright and delivers it to unwind the
out again and, using the funds obtained from the reverse, using the funds to pay for the purchase
repo, reverse in the on-the-run Treasury again (see (see Chart 6). If all goes well, the dealer earns a bid-
Chart 5). When a purchaser arrives, the dealer sells ask spread that compensates for the cost of holding
the original security, uses the funds to unwind the and hedging the inventory.4

3. This greater liquidity is reflected in smaller bid-ask spreads for the on-the-run security.
4. Implicitly, it is assumed that dealers can borrow the full value of a Treasury security. For interdealer transactions, this
assumption is not unrealistic. In other transactions, dealers and/or customers face haircuts, which amount to margin require-
ments. A more accurate accounting of haircuts (larger haircuts for customers than for dealers) would complicate the story
without changing the central results significantly.

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 31

 Recall that the hedge is a short position in an collateral rate, where R ≤ r.5 The repo spread is
on-the-run Treasury security. In the example, the given by s = r – R. If R < r, then the repo spread is
hedged asset is another (older, less liquid) Treasury positive and the collateral is on special. Let p denote
security. Dealers hedge a variety of fixed-income the value of the specific collateral.
securities by taking short positions in on-the-run The repo spread allows the holder of the collateral
Treasuries. For example, dealers hedge mortgage- to earn a repo dividend.6 Let δ denote the repo divi-
backed securities by selling short the on-the-run dend, which equals the repo spread times the value of
ten-year Treasury note. As noted above, on-the-run the bond: δ = (r – R)p = sp. A dealer holding some
Treasuries are more liquid than older Treasuries; collateral on special (that is, for which R < r) can cap-
indeed, on-the-run Treasuries are perhaps the most ture the repo dividend as follows (see Chart 7). The
liquid securities in the world. Liquidity is especially dealer repos out the specific collateral (borrows p at
important for short sellers because of the possibility rate R) and simultaneously reverses in general collat-
of being caught in a short squeeze. In a short squeeze, eral of the same value (lends p at rate r). The net
cash flow is zero and the net change in risk is (effec-
tively) zero. Next period the dealer unwinds both
transactions, receiving the specific collateral back in
exchange for paying (1 + R)p and receiving (1 + r)p
Dealers’ hedging activities create a link in exchange for returning the general collateral. The
between the repo market and the auction dealer’s net cash flow is the repo dividend (r – R)p.
cycle for newly issued (on-the-run) Who would pay a repo dividend? The discus-
sion has just shown how a dealer can obtain a repo
Treasury securities. dividend when a security it possesses is on special
in the repo market. But what happens to the dealer’s
counterparty in the repo transaction? The counter-
party (who may be another dealer) has just lent
it is costly to acquire the collateral for delivery on money at less than the risk-free rate. Why would any-
the short positions. Because the probability of being one do such a thing? In other words, why would
squeezed is high for large short positions, such posi- anyone pay a repo dividend?
tions are not typically established in illiquid securi- If the counterparty (the party that is lending the
ties; consequently, squeezes are rarely seen in illiquid money and acquiring the collateral) puts extra value
securities, which is to say the unconditional prob- on the specific collateral in question (above and
ability is low. The equilibrium result is that squeezes beyond the value put on similar collateral), then that
arise most often in very liquid securities (uncondi- party will be willing to pay a fee for the privilege
tionally), because the (conditional) probability of of obtaining the specific collateral. The dealer can
being squeezed is low. package the fee as a repo dividend by having the
counterparty accept a lower interest rate on the loan.
Repo Rates and the Repo Dividend In such a case, the specific collateral repo rate will be
below the general collateral repo rate (below the
A s noted above, repurchase agreement transac-
tions can be thought of as collateralized loans.
The loan is said to finance the collateral. For most
risk-free rate). But this scenario begs the question,
Why would anyone put extra value on some specific
publicly traded U.S. Treasury securities the financ- collateral? Why are other similar bonds not suffi-
ing rate in the repo market is the general collateral ciently close substitutes? The answer is simple:
rate (which can be thought of as the risk-free interest Anyone who sold that specific collateral short must
rate). In contrast, for some Treasury securities— deliver that bond and not some other bond. In other
typically recently issued securities—the financing words, traders with short positions are willing to pay
rate is lower than the general collateral rate. These a repo dividend. These traders may well be dealers
securities are said to be on special, and their financ- who have established short positions to hedge other
ing rates are referred to as specific collateral rates, securities acquired in the course of making markets.
also known as special repo rates. The difference From their perspective, they are entering into
between the general collateral rate and the specific reverse repos in order to acquire the collateral. By
collateral rate is the repo spread. the same token, investors who do not hold short posi-
Let r denote the current one-period general col- tions will be unwilling to pay the repo dividend. They
lateral rate (also referred to as the risk-free rate), place no special value on the specific collateral and
and let R denote the current one-period specific accept collateral only at the general collateral rate.

32 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

 CHART 7
Capturing the Repo Dividend
gen. collat. spec. collat.
At inception: Customer 1 Dealer Customer 2
funds funds

gen. collat. spec. collat.

At maturity: Customer 1 Dealer Customer 2
(1 + r) × funds (1 + R) × funds

A dealer can capture the repo dividend by repoing out the specific collateral that is on special and simultaneously reversing in general col-
lateral. The dealer nets (r – R) times the value of the specific collateral financed in the repo market.

What determines the repo spread? One can

CHART 8
adopt a simple model of supply and demand to ana-
lyze how the repo spread is determined. Chart 8 An Equilibrium Repo Spread
shows the demand for collateral by the shorts
(those who want to do reverses) and the supply of Repo spread Supply (repo)
collateral by the longs (those who want to do repos).
The horizontal axis measures the amount of trans-
Demand (reverse)
actions, and the vertical axis measures the repo
spread. The equilibrium repo spread and amount of
transactions are determined by where supply and
r–R
demand intersect. In the chart, the security is on
special since the repo spread is positive. If instead
the demand curve hit the horizontal axis to the left
of Q0, then the repo spread would be zero and the
Repo
security would be trading at general collateral in the Q0 trans.
repo market.
Up to Q0, the supply curve is perfectly elastic at The supply of repos and the demand for reverse repos determine
a zero spread (R = r). There is a group of holders the repo spread, r – R. If the demand intersects the horizontal
(those who hold the collateral) who will lend their axis to the left of Q0, then the repo spread will be zero.
collateral to the repo market at any spread greater
than or equal to zero. Beyond Q0, the supply curve
slopes upward. To attract additional collateral, the $5 billion of that security. In this situation, a given
marginal holders require larger and larger spreads. piece of collateral is used to satisfy more than one
But why is the supply curve not infinitely elastic at short position; this scenario demonstrates the velocity
all quantities? The fact that the supply curve rises of collateral. In effect, the market expands to match
at all indicates that some holders forgo repo spreads the supply, at least to some extent. However, main-
of smaller magnitudes. In fact, there are some hold- taining this velocity involves informational and
ers who do not offer their collateral at any spread. technological costs. As the amount of short interest
At least for smaller spreads, transactions costs of increases and more collateral needs to be reversed
various sorts can account for the upward slope. In in, identifying holders who are willing to lend col-
addition, some holders are restricted legally or lateral becomes more difficult. Some who held col-
institutionally from lending their collateral. lateral earlier in the day may no longer have it; others
There is an important aspect of the repo market who did not have it earlier may be holders now.
that is not explicitly modeled here: The amount of Overall, several features may contribute to the
short interest may exceed the total quantity of the upward slope of the supply curve.
security issued by the Treasury. For example, there The auction cycle. The supply and demand
may be short positions totaling $20 billion in a given framework can be used to illustrate the average pat-
security even though the Treasury has issued only tern of overnight repo spreads over the course of the

5. For institutional reasons, R ≥ 0 as well.

6. Unlike most of the technical terms in this article, the term repo dividend is not standard.

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 33

 CHART 9 CHART 10
The Effect of a Decrease in the The Average Pattern of Overnight Repo Spreads
Repo Supply Curve
200
Repo spread
175

B a s is p o in t s p e r d a y
150
r – R' 125
100
75
r–R
50
25

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Repo We e ks sin c e issu a n c e
Q'0 Q0 trans.

The chart shows the average pattern of overnight repo spreads

A decrease in the supply of collateral leads to an increase in the for an on-the-run security with a three-month (thirteen-week) auc-
repo spread from r – R to r – R ′ or, equivalently, a fall in the tion cycle. The current on-the-run security is issued at week 0. The
special repo rate from R to R ′. next security is announced at week 11 (at which point forward
trading in the next security begins), auctioned at week 12, and
issued at week 13. The overnight repo spreads reach a peak of
200 basis points per day at week 11. This cycle produces 0.5 ×
auction cycle. For example, the U.S. Treasury typi- 91 × 200 = 9,100 basis-point days of repo dividend earnings (the
total area under the curve).
cally auctions a new ten-year Treasury note every
three months (at the midquarter refunding in
February, May, August, and November).7 There are
three important periodic dates in the auction cycle: overnight spread descending to (and presumably
the announcement date, the auction date, and the staying at) zero in week 13. This diagram is an
settlement (or issuance) date. On the announcement adequate approximation for the three-year note
date, the Treasury announces the particulars of the but it is not a good approximation for the ten-year
upcoming auction—in particular, the amount to be note, for which the overnight repo spread can
auctioned—and when-issued trading begins.8 The average 25 to 50 basis points during the following
auction is held on the auction date and the security auction cycle. In the next section, the analysis will
is issued on the settlement date. There is usually demonstrate how the expected future overnight
about one week from the announcement to the auc- repo spreads are reflected in the price of the on-
tion and one week from the auction to the issuance. the-run bond.
During a typical (stylized) auction cycle, the
supply of collateral available to the repo market is at Repo Dividends and the Price of the
its highest level when the security is issued in the Underlying Bond
sense that Q0 ≥ Q, so that the overnight repo spread
is zero. As time passes, more and more of the secu-
rity is purchased by holders who do not lend their
A simple rule can be used to determine what the
expected payment of a repo dividend does to the
price of a bond: The expected return on the bond
collateral to the repo market. Consequently, Q0 (which includes the repo dividend) is unchanged. The
declines over time, shifting the supply curve to the expected return is simply repackaged; whatever goes
left and driving the repo spread up (see Chart 9). into the repo dividend yield comes out of the capital
When forward trading in the next security begins on gain. In other words, the spot price will rise until the
the announcement date, the holders of short posi- expected return on the bond is exactly the risk-free
tions roll out of the outstanding issue; the demand rate, r, as the following analysis demonstrates.
curve shifts rapidly to the left and drives the repo Let p denote the current price of an n-period
spread down. default-free zero-coupon bond, and let p′ denote the
Chart 10 shows how the shifts in supply and price of that bond next period when it becomes an
demand described above are reflected in the aver- (n – 1)-period bond. Recall that r is the one-period
age pattern of overnight repo spreads for an on- risk-free interest rate (which is the same as the gen-
the-run security with a three-month auction cycle. eral collateral rate). In this case (assuming there is
Actual auction cycles display a huge variance no uncertainty for the time being), the current price
around this average. The chart shows the average equals the present value of next period’s price:

34 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

 p′ A forward contract is an agreement today to
(1) p= . deliver something on a fixed date in the future
1+ r
(the delivery date) in exchange for a fixed price
For a one-period bond, p′ = 1 and p = 1/(1 + r). If (the forward price). A repo establishes a forward
the bond paid a dividend, δ, at the end of the period, position, and the repo rate on a bond is simply a
then the current price would reflect the present way of quoting the forward price of the bond. An
value of that dividend as well: n-period default-free zero-coupon bond with a
face value equal to 1, by definition, pays its owner
p′+ δ
(2) p= . 1 after n periods. Let p denote the current (spot)
1+ r
price of this bond, F denote the forward price of
If the dividend is in fact a repo dividend, where δ = the bond for delivery next period, and R denote
(r – R)p, then the (one-period) repo rate for the bond. A long
forward position is established by buying the bond
p′+ ( r − R )p
(3) p= . for p and financing it in the repo market for one
1+ r
period at rate R. (The net cash flow at purchase is
Because both sides of equation (3) involve the cur- zero.) In the next period, one pays (1 + R)p and
rent price, p, the equation can be solved as follows: receives the bond.9 Therefore, the forward price is
F = (1 + R)p.10 In fact, the repo rate is defined by
p′
(4) p= . R = F/p – 1.
1+ R
If current information is available, one knows
Note the similarity of equation (4) to equation (1). the current bond price, p; the current repo rate, R;
The value of a bond that pays a repo dividend equals and the current risk-free rate, r. But one does not
next period’s price discounted at its own repo rate. know for sure the price of the bond next period, p′
Equation (4) reduces to equation (1) when R = r. (unless it is a one-period bond, in which case p′ =
Rearranging equation (2) produces 1). Assuming that one knows the probability distri-
bution of p′, then one knows the average price
p′ − p δ
(5) + = r, (also known as the expected price). Let E[ p′]
p p denote the expected price. The actual price of the
where the first term on the left-hand side of equa- bond next period, p′, equals its expected price plus
tion (5) is the capital gain and the second term is a forecast error ε that is independent of everything
the (repo) dividend yield (δ/p = r – R). Neither the currently known:
risk-free rate, r, nor next period’s bond price, p′,
depends on the current repo dividend, δ, or the cur- (6) p′ = E[ p′] + ε.
rent repo rate, R. Comparing two securities with
different repo rates reveals that, for the bond with The forward price, F, is also known today. The
the lower repo rate, (1) the repo dividend is higher, forward premium, p, is defined as the difference
(2) the dividend yield is higher, (3) the current between the expected and the forward price:
bond price is higher, (4) the capital gain is smaller,
and (5) the expected return is the same. (7) π = E[ p′] – F.
Uncertainty and the forward premium. When
uncertainty is introduced, risk premiums must be The forward premium is a risk premium. Given p =
accounted for. Risk premiums compensate investors F/(1+R) and the definition of the forward premium,
for bearing risk by increasing the expected return.
E[ p′] − π
Because repo transactions are essentially forward (8) p= .
contracts, it is convenient to introduce risk premiums 1+ R
through the forward premium.

7. Occasionally, instead of issuing a new security the Treasury reopens the existing on-the-run security, selling more of the
same security at the next auction. See the discussion on reopenings below.
8. When-issued trading refers to forward transactions for delivery of the next issue when it is issued.
9. A short forward position is established by selling the bond short for p and financing it in the repo market (on a reverse repur-
chase agreement) for one period at rate R. Next period, one receives (1 + R)p and delivers the bond.
10. The forward price does not depend on the price of a one-period bond as is sometimes incorrectly assumed. See Appendix 2
for a discussion of how this miscalculation of the forward price can lead to a false rejection of the expectations hypothesis.

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 35

Using R = r – δ/p to eliminate R,11 equation (8) can next period and its current expected price can be
be reexpressed as expressed as follows:
E[ p′] − p δ π n−1 n−1
(9) + =r+ , (13a) p′ ≈ 1 + ∑ s( i) − ∑ r ( i), and
p p p i=1 i=1

which demonstrates that the expected return (cap- n−1 n−1

ital gains plus repo dividends, both as fractions of (13b) E[ p′] ≈ 1 + ∑ E[ s( i) ] − ∑ E[r ( i) ],
i=1 i=1
the investment) equals the risk-free rate plus a risk
premium. Equation (9) reduces to equation (5) where the indexes in the sums begin at one instead of
when there is no uncertainty. The comparison fol- zero. Subtracting equation (13b) from (13a) yields,
lowing equation (5) between two bonds with dif- n−1 n−1
ferent repo rates applies just as well when there (14) p′ − E[ p′] ≈ 1 + ∑ (s( i) − E[ s( i)]) − ∑ ( r ( i) − E[r ( i) ]).
i=1 i=1
is uncertainty.
Future repo rates. In order to express equa- In equation (14), the uncertainty is decomposed
tion (4) in terms of future repo rates, one can into two components: uncertainty associated with
assume for the moment there is no uncertainty. future repo spreads and uncertainty associated with
Recall that p is the price of an n-period zero- future interest rates. If a dealer is using the bond to
coupon bond. For a one-period bond, p′ = 1, and hedge another position, then the effect of unantici-
equation (4) implies that p = 1/(1 + R). For a bond pated changes in future interest rates on the bond’s
with a maturity of two periods or more, let p′′ price is offset by the hedged position (by assumption).
denote its price two periods hence when it However, the effect of unanticipated changes in future
becomes an (n – 2)-period bond. Similarly, let r′ repo spreads is not offset. The dealer faces this very
and R′ denote the values next period of the short- real risk when using short positions in on-the-run
term interest rate and the repo rate. Then, follow- securities to hedge other securities. If expected future
ing the same steps that led to equation (4), repo spreads fall while the dealer’s short position is
open, the dealer may be forced to repurchase the
p′′
(10) p′ = . bond at a significantly higher price when the hedge
1 + R′ is removed, leading to possibly substantial losses.
Using equation (10) to eliminate p′ from equation The price premium and future repo spreads.
(4) yields p = p′′/(1 + R)(1 + R′). For a two-period The analysis next compares the price of an n-period
bond, p′′ = 1 and p = 1/(1 + R)(1 + R′). An analo- bond that may earn repo dividends (specific collat-
gous expression holds for bonds of longer maturi- eral) with the price of a baseline n-period bond that
ties. If p is the price of an n-period bond, then earns no repo dividends.13 To simplify the exposi-
n−1
tion, it is assumed there is no uncertainty.
1
(11) p= ∏ , Let the price of the specific collateral be p and
i=0 1 + R
(i)
the price of the baseline bond be p –. The price pre-
where R(0) = R, R(1) = R′, R(2) = R′′, etc. Equation mium of the specific collateral over the baseline
(11) expresses the bond price as the present value bond can be measured as ψ = log(p/p – ). The price of
of the final payment discounted at its current and the baseline bond can be expressed in terms of the
future one-period repo rates.12 As an approxima- current and future one-period risk-free interest
tion, equation (11) can be written as rates (general collateral rates) (compare equation
[11]): p– = Π n–1 /(1 + r(i)), where r (0) = r, r (1), r (2) =
n−1 n−1 n−1 n−1 i=0
1
(12) p = ∏ ≈ 1 − ∑ R( i) = 1 + ∑ s( i) − ∑ r ( i), r′′, and so on. Then the price premium is given by
i=0 1 + R
(i)
i=0 i=0 i=0
 n−1 1 
where the repo rates are expressed in terms of the ∏
 i=0 1 + R( i )  n−1
risk-free (general collateral) rate and the repo spread, (15) ψ = log  = ∑ (log(1+ r ) − log(1+ R ))
(i) (i)

R(i) = r(i) – s(i). Equation (12) shows that higher repo  ∏ni=−01 1 ( i )  i=0
spreads lead to higher bond prices while higher risk-  1+ r 

free rates lead to lower bond prices. n−1 n−1

If uncertainty is introduced into future risk-free ≈ ∑ ( r ( i) − R( i) ) = ∑ s( i) .
i=0 i=0
rates and repo spreads (the current risk-free rate, r,
and repo spread, s, are known, of course) and if, for The relative price premium equals (to a close
expositional simplicity, all uncertainty is assumed to approximation) the sum of the current and future
be resolved next period, then the price of the bond repo spreads. A bond may have a significant price

36 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

 CHART 11
premium, even though it has no current repo divi-
The Average Price Premium
dends, as long as it has future repo dividends. This
pattern can be seen in the Treasury market. When 25
a bond is first issued, typically it has a significant
price premium even though it is not on special for 20

B a s is p o in t s
overnight repo transactions. Later, however, the
15
overnight rates typically move lower than the general
collateral rates, opening up a significant repo spread. 10
Given equation (15), the price premium can be
expressed as ψ ≈ s + ψ′, where ψ′ = Σ i=1 s(i) is the
n–1
5

price premium next period. This relation between ψ

and ψ′ shows that the price premium declines over 0 1 2 3 4 5 6 7 8 9 10 11 12 13

time as the repo dividends are paid: ψ′ – ψ ≈ –s. The We e ks sin c e issu a n c e

larger the repo spread, the greater the decline in the The chart shows the average price premium for an on-the-run
price premium; conversely, if the current repo spread security with a three-month (thirteen-week) auction cycle. This
price premium is computed from the stylized overnight repo
is zero, then the price premium does not decline.
spreads in Chart 10. The price premium is the sum of all remain-
The presence of uncertainty complicates the sit- ing repo spreads. When the security is issued, it has a price pre-
uation slightly. If there is uncertainty about future mium of about 25 basis points of the value of a reference bond.
(The bid-ask spread for an on-the-run security is less than or equal
repo spreads, then revisions in their expectations will
to 1/32 per 100 = 3.125 basis points.)
also affect the change in the price premium. In this
case, it is the expected change in the price premium
that is approximately equal to (the negative of) the Implications and Discussion
current one-period repo spread: E[ψ′] – ψ ≈ –s.
Chart 11 shows the price premium, π, computed
from the repo spreads shown in Chart 10. Equation
F actors that determine the total specialness.
One implication of the analysis is that the size of
the price premium at the auction depends on the
(15) provides the link between the two graphs. The total number of basis-point days of “specialness”
height of the curve in Chart 11 for a given week that the security will generate during its life. The
equals the sum of the remaining repo spreads, which security’s total specialness can increase either
in turn equals the area under the curve in Chart 10 to through the overnight spread increasing or by the
the right of that week. Thus, the premium of 25 basis security being on special for a longer time. For
points at week 0 in Chart 10 equals the total area example, the main reason the price premium for the
under the curve.14 The premium of 25 basis points is two-year note is small on average (less than 10 basis
in line with that for the thirty-year bond during the points) is that it is on a monthly cycle and therefore
late 1980s and early 1990s. During the same period has only about thirty days to accumulate repo divi-
the average price premium at issuance for the ten- dends versus the ninety-one days for securities with
year note was about 60 basis points while it was about a three-month cycle. As noted above, securities that
10 basis points for the three-year note. These average are on quarterly cycles typically have larger price
price premia all display the same general shape as premiums; the significant variation across the price
that displayed in Chart 11. The one significant differ- premiums of such securities can be attributed to
ence is that the ten-year note retained a 20 basis the average size of the spreads.15
point premium throughout the following cycle. The Occasionally, instead of selling a new security at
huge variance around the average pattern shown in the next auction, the Treasury reopens the existing
Chart 11 is consistent with the variance around the on-the-run security. Such a reopening extends the
pattern of overnight repo rates shown in Chart 10. length of time the security is on the run. Since the

11. Recall that δ = (r – R)p.

12. Consequently, the yield to maturity on a bond is (approximately) the average of these repo rates: –log(p)/n = Σi=0 log(1 + R(i))/n
n–1

≈ Σi=0 R(i)/n.
n–1

13. There are a sufficient number of securities that can reasonably be assumed to satisfy this condition so that the value of a
baseline bond can be calculated for any specific security.
14. The repo spreads in Chart 10 are quoted in basis points per day, which must be converted to basis points per year before
they can be plugged into Equation (15). The total area under the curve in Chart 10 is 1/2 × 91 × 200 = 9,100 basis-point days,
which equals approximately 25 basis-point years.
15. In addition, owing to institutional details, the repo spread cannot exceed the general collateral rate, so it is possible to have
larger repo spreads when short-term rates are higher.

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 37

 supply available to the repo market is replenished by Not all reopenings increase the length of time a
the new issuance, overnight repo rates tend to follow security remains on the run. In the wake of the dis-
the same pattern on average for a reopened issue. aster in New York City on September 11, 2001, the
Nevertheless, if such a reopening can be forecast Treasury conducted a surprise reopening of the ten-
ahead of time, all of the repo dividends from the next year note in the middle of the auction cycle. This
auction cycle will be capitalized into the value of the reopening had the desired effect of increasing the
current on-the-run security, raising the premium. supply available to the repo market and raising
A number of factors that affect the total special- overnight repo rates significantly. The reopening
ness came together to produce a spectacularly large apparently also had a salutory effect on other issues
price premium for one issue. In the early 1990s, the as market participants recognized the Treasury’s will-
Treasury changed the auction cycle for the thirty- ingness to undertake such reopenings as it saw fit.
year bond from quarterly to semiannually. This Convergence trades. The price premium that
change effectively doubled the number of days that the on-the-run bond commands typically disappears
by the time it goes off the run; that is, the on-the-
run security displays a predictable capital loss rel-
ative to the baseline security (which for practical
An increase in expected future short selling purposes can be taken to be the old security). In
drives up the current price of a Treasury other words, the price of the on-the-run security
converges to the price of the baseline bond. The
bond because future repo dividends are
popular press has described a convergence trade
capitalized while the expected return on that purports to profit from this price convergence.
the security is unchanged. But, as discussed earlier, the systematic movement
in relative prices is offset by the relative financing
costs. Although individual episodes may have pro-
duced substantial profits for convergence trades,
the new thirty-year would maintain its on-the-run other episodes have produced substantial losses.
status. Therefore, it was reasonable to forecast that On average such trades are not profitable.
the total amount of specialness that would accrue If uninformed speculators came to dominate the
to the bond had increased significantly, and capital- short interest in the on-the-run security in a mistaken
izing those increased dividends led to a price pre- attempt to profit from convergence, such specula-
mium that was substantially larger than usual. tors would change the dynamics of the auction cycle.
Once the price premium reached a certain critical Convergence occurs precisely because the shorts
amount, another factor entered the picture. Just (who ordinarily are hedgers) roll out of the current
prior to the change in the auction cycle, the Treasury on-the-run security and into the next issue, thereby
had committed to reopening any security for which eliminating the possibility of substantial future repo
there appeared to be a significant “shortage.” A sig- dividends for the current issue. By contrast, conver-
nificant price premium was considered to be one gence traders (who are also short) will wait until the
symptom of a shortage. When the Treasury changed liquidity premium disappears before they close their
the auction cycle, there had not yet been an oppor- short positions. But if convergence traders constitute
tunity to demonstrate a willingness to follow through a sufficient amount of short interest, then their short
on the stated commitment, and it was widely positions—by themselves—will keep the liquidity
believed that the Treasury would do so at the first premium from disappearing. At this point, other
opportunity. With the price premium on the thirty- speculators who simply observed the price premium
year bond reaching new heights, it was reasonable to without considering the repo market might conclude
forecast that the Treasury would reopen the bond at that a special profit opportunity had appeared and
the next auction (six months hence) with the result jump into the convergence trade, further increasing
that the bond would remain on the run for a whole the repo spread and price premium. Those who
year. Given this belief, it was reasonable to forecast jumped in early would find the premium has
the amount of specialness that would accrue to the diverged instead of converged.
thirty-year had increased significantly yet again. As a
consequence, the price premium increased even The Repo Squeeze
more, tending to confirm the belief that the Treasury
would reopen the bond, and such a reopening is of
course just what occurred.
T he analysis thus far has assumed that the repo
spread is determined in a market in which no
agent has (or exercises) market power. By contrast,

38 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

 CHART 12
an agent with a sizable position to finance faces an
Maximizing the Repo Dividend
interesting problem—how to finance at the cheapest
possible rate given that the amount financed may
Repo spread
affect the rate paid. In order to understand the trade- D S
offs a repo trader faces in choosing the optimal mix,
Net demand
it is necessary to be familiar with a triparty repo.
r – R*
Triparty repo. To obtain reliable sources of Repo MR
funding, dealers quite commonly establish ongoing S* q*
trans.
q*
relationships with customers seeking safe short-
term investments for their funds such as repos. To
In the left panel, the demand curve for collateral by the shorts is
facilitate this relationship, the dealer and the cus- labeled D, and the supply curve of collateral by others is
tomer may enter into a triparty repo agreement in labeled S. In the right panel, the difference between D and S is
the net demand facing the trader, and the diagonal dashed line is
which the third party is a clearing bank. Both the
marginal revenue. The arrow indicates the profit-maximizing (or
dealer and the customer must have clearing cost-minimizing) quantity of collateral to supply directly to the
accounts with the bank. The bank provides a num- market, q*. The area of the rectangle is the maximized repo divi-
dend, (r – R*)q*. If the trader’s total amount to be financed, Q, is
ber of services, including verifying that the collat-
greater than q*, then the difference, Q – q*, is financed via a
eral posted by the dealer meets the prespecified triparty repo. The amount supplied by others is S*.
requirements of the customer. An important aspect
of a triparty repo is that the transfer of collateral
and funds between the dealer and the customer applied to the total amount of collateral, rQ, less the
occurs entirely within the books of the clearing repo dividend on the amount financed directly in
bank and does not require access to Fedwire. This the market, (r – R)q. Thus, minimizing the finance
feature is convenient because it allows for repo cost is the same as maximizing the repo dividend.
transactions to be consummated late in the day The problem for a trader with a large position is that
after Fedwire is closed for securities transfers, an increase in q leads to an increase in R, decreas-
which typically is midafternoon. ing the spread, r – R. Whether the repo dividend
The repo squeeze. Suppose a repo trader has a goes up or down when q increases depends on just
sizable (long) position in a Treasury security to how responsive the special repo rate is to the
finance. The position may have been acquired out- amount of collateral lent directly to the market.
right by the dealer’s Treasury desk or it may have In effect, the trader has the same problem as a
been acquired by the repo trader himself via monopolist: The amount “produced” (q) affects the
reverse repos for some term to maturity. The collat- price (r – R). The trader faces a downward-sloping
eral can be financed either directly in the market at demand curve. In this case, the demand curve fac-
rate R or via a triparty repo at the general collateral ing the trader is a net demand curve, in which the
rate, r.16 What makes this choice interesting is that supply of collateral by others is subtracted from the
the amount the trader finances directly in the market demand for collateral by the holders of short posi-
may affect the repo rate itself. If the trader’s position tions.17 This situation is depicted in Chart 12. The
is substantial, then as more and more collateral is quantity that maximizes the repo dividend (q*) is
lent directly in the repo market, the special repo determined by the condition that marginal revenue
rate will rise. In this case, the traders must take be zero. If Q ≤ q*, then all the collateral is financed
care to compute the financing mix that minimizes directly in the market. On the other hand, if Q > q*,
the total financing cost. then q* is financed directly in the market and Q – q*
Let Q denote the total amount of collateral to be is financed via a triparty repo at the higher rate, r.
financed and q denote the amount financed directly This situation (that is, when Q > q*) is known as
in the market so that Q – q is the amount financed a repo squeeze. There are two essential ingredients
via a triparty repo. Therefore, the cost of financing for a repo squeeze. First, there must be outstanding
the collateral is Rq + r(Q – q). This financing cost short positions; otherwise, the security could not go
can be rewritten as rQ – (r – R)q, which expresses on special. Second, the trader must have possession
the financing cost as the general collateral rate of the collateral, by having acquired it outright or

16. The dealer’s counterparty on a triparty agreement has no interest in whether any of the collateral in its triparty repo account
at its clearing bank is on special, and it will not accept less than the general collateral rate on its loans to the dealer secured
by that collateral.
17. The trader plays the role of the dominant firm among a competitive fringe of other suppliers.

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 39

via term reverse repos. (For collateral acquired via Conclusion
reverse repo, the term of the repo limits the dura-
tion of the repo squeeze; when the reverses mature,
the collateral must be returned.) One should recog-
T his article has presented the somewhat surpris-
ing proposition that an increase in expected
future short selling drives up the current price of a
nize that the “profits” from a repo squeeze come Treasury bond because future repo dividends are
from driving the repo spread up and earning a larger capitalized while the expected return on the security
repo dividend than otherwise. While it is true that a is unchanged. The repo dividends arise when a bond
repo squeeze drives the price of the security higher goes on special—that is, when the bond’s repo rate
than it otherwise would be, this feature is a side falls below the risk-free rate. The liquidity premium
effect. Since a squeeze can be maintained only by for an on-the-run Treasury security can be attributed
one who controls the collateral, selling the security to this effect.
is counterproductive. The premium goes away when the bond goes
Note that if the repo squeeze is fully anticipated, off the run because the holders of short positions
the shorts bear no cost since they establish their roll out of the current issue and into the new issue,
short positions at appropriately high prices. By the thereby eliminating the possibility of significant
same token, the trader earns no profits from a fully future repo earnings. The on-the-run security’s pre-
anticipated squeeze since the prices at which he dictable capital loss relative to other bonds is off-
acquired the security fully reflected his actions. set by its financing cost relative to other bonds.
Thus, a repo squeeze is profitable only if it is not Consequently, there are no profits to be made from
fully anticipated. so-called convergence trades on average.

40 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

APPENDIX 1
Term Structure of Repo Spreads

T hus far, the discussion has considered only one-

period repo transactions, that is, those in which
the securities have been repoed (or reversed) for
s(i)/n, which shows that the term repo spread is
(approximately) the average of the one-period
repo spreads. Moreover, the term structure of
one period only. However, term repo transactions repo spreads can be used to forecast the dynam-
are quite common. In a term repo, a single, fixed ics of the price premium. In particular, the n-period
repo rate is agreed to at the inception of the trans- change in the price premium is approximately
action. Perhaps the best way to think about term equal to (the negative of) the n-period term repo
repo rates is as a way of quoting forward prices for spread, ψ(n) – ψ ≈ –sn, where ψ(n) is the price pre-
delivery more than one period in the future. mium n periods later. Uncertainty, of course,
Consider an n-period bond that has a current complicates matters a bit: E[ψ(n)] – ψ ≈ –sn.
price of p. To establish a long forward position in The chart displays the average pattern of three
the bond for delivery in two periods, one buys the term repo spreads over the course of a three-month
bond and repos it in the term repo market for two auction cycle. The term spreads are computed in
periods at the rate of R2 per period. The current accordance with the expectations hypothesis from
cash flow is zero. At time two, one pays (1 + R2)2p the average pattern of overnight spreads shown in
and receives the bond. Thus, F2 = (1 + R2)2p, where Chart 10. These term repo spreads are in line with
F2 is the forward price of a given bond for delivery those observed on the market.
in two periods. In general, the forward price for
delivery in m periods is Fm = (1 + Rm)mp, where Rm
is the m-period repo rate (per period) and Fm is the CHART
forward price for delivery in m periods.
The Term Structure of Repo Spreads
Compare the cost of financing a bond for m
periods with a term repo versus rolling over one- 200
period financing. In the first case the cost is (1 +
Ba sis p o in ts p e r d a y

175
Rm)m while in the second case the cost is Π i=0(1
m–1

(1)
150
+ R ). When there is no uncertainty, these two
125
costs must be the same, implying an expectations 100
hypothesis for repo rates: Rm ≈ Σ i=0 R(i)/m.
m–1

– ). 75
Consider again the price premium, ψ = log(p/p
– 50
For the baseline n-period bond, p = 1/(1 + rn)n,
25
where rn is the yield to maturity of the baseline
bond (which earns no repo dividends). The price 0 1 2 3 4 5 6 7 8 9 10 11 12 13
We e ks sin c e issu a n c e
premium can be reexpressed as
Term repo spreads are computed from the stylized overnight
 1/(1 + Rn )n  repo spreads in Chart 10: thirty-day (solid), sixty-day (dashed),
(A1.1) ψ = log n
≈ n( rn − Rn ) = nsn , and ninety-day (dotted). When the security is issued at week 0,
 1/(1 + rn )  the term structure slopes upward, anticipating the rise in
overnight rates; the thirty-day spread is about 39 basis points
while the ninety-day spread is about 100 basis points. By week
where sn = rn – Rn is the term repo spread. 8, the term structure slopes steeply downward; the thirty-day
spread is about 160 basis points while the ninety-day spread
Comparing the expression for ψ in equation is about 56 basis points.
(A1.1) with that in equation (15) yields sn ≈ Σi=0
n–1

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002 41

 APPENDIX 2
Forward Prices and the Expectations Hypothesis

Finally, if π is constant, then equation (A2.3)

T he forward rate, F, can be used to forecast the
bond price next period, p′. A linear forecast
has the form p̂′ = α + βF, where p̂′ is the forecast.
reduces to
Var[ E[ p′]]
The coefficients α and β are constants that can be β= = 1.
chosen to produce unbiased forecasts and to min- Var[ E[ p′]]
imize the variance of the forecast error, p′ – p̂′.
The slope coefficient, β, is computed as A number of empirical studies have purported to
estimate β for U.S. data. These estimates typically
reject the hypothesis that β = 1 and conclude there-
Cov[ p′, F ]
(A2.1) β= , fore that π is not constant. The following discussion
Var[ F ] illustrates how these studies may have incorrectly
computed forward rates. Consequently, the slope
where Cov[p′, F] is the covariance between p′ coefficient that was estimated involves additional
and F and Var[F] is the variance of F.1 If the factors that were ignored.
expectations hypothesis holds, then β = 1, in Pseudo forward rates. The way of computing
which case p̂′ = α + F and changes in the fore- forward prices that has been used in many empir-
cast (∆p̂′) correspond to changes in the forward ical studies is incorrect and can lead to spurious
price (∆ F).2 The forward risk premium plays a rejections of the expectations hypothesis.
central role in determining whether the expec- As before, let p denote the current price of an
tations hypothesis holds. It will be shown that if n-period bond (where in this case n ≥ 2). Define
π is constant (that is, if π is the same in every the pseudo forward price of the bond as F̃ = p/p1,
period), then β = 1. where p1 is the current price of a one-period
The strategy is to write both F and p′ in terms bond. The price of the one-period bond can be
of E[p′] by using the definition of the forward pre- written in terms of its own one-period repo rate:
mium in equation (7) and the relation between p1 = 1/(1 + R1), where R1 is the one-period repo
next period’s price and its current expectation in rate for the one-period bond. Thus, the pseudo
equation (6). Substituting these expressions for forward price can be expressed as F̃ = (1 + R1)p.
F and p′ into equation (A2.1) produces Comparing this expression for F̃ with the expres-
sion for the true forward price, F = (1 + R)p,
shows that F̃ uses the wrong repo rate. The defi-
Cov[ E[ p′ ] + ε, E[ p′] − π]
(A2.2) β= . nition of the pseudo forward price implicitly
Var[ E[ p′] − π] assumes one can finance the n-period bond at R1
rather than at its own repo rate R.
In the numerator of equation (A2.2), the properties Defining the pseudo forward premium, π̃ =
of covariances and the independence of ε imply 3 E[p′] – F̃, note that π̃ = (E[p′] – F) + (F – F̃) = π +
(R – R1)p. In other words, the pseudo forward
premium equals the true forward premium plus
Cov[ E[ p′] + ε, E[ p′] − π] = Cov
144 p′],
[ E[2 44 ′]]
E[ p3 another term that reflects the difference between
=Var[ E [ p′ ]] the two repo rates. Even if the true forward pre-
− Cov[E[ p′], π] mium were identically zero, the pseudo forward
+ Cov[ε, E[ p′]] − Cov[ε, π] premium would equal (R – R1)p.
14 4244 3 1424 3 Suppose the pseudo forward price (instead of
=0 =0
= Var[ E[ p′]] − Cov[ E[ p′], π]. the true forward price) is used to forecast the
price of the bond next period. Let the linear fore-
cast be given by α̃ + β̃ F̃, where the coefficients α̃
The regression coefficient can now be reexpressed: and β̃ are chosen to minimize the forecast error.
The slope coefficient is
Var[ E[ p′]] − Cov[ E[ p′], π]
(A2.3) β= .
Var[ E[ p′] − π] Cov[ p′, F˜ ]
β˜ = .
(A2.4) Var[ F˜ ]

42 Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2002

 A P P E N D I X 2 (continued)

If π is constant but R1 – R is random, then β̃

β ≠ 1. By the properties of variance,4 equation (A2.5) can
Following the steps above that lead from equation be expressed as
(A2.1) to equation (A2.3), but replacing F and π
A
with F̃ and π̃, leads from equation (A2.3) to (A2.6) β˜ = ,
A+ B

Var[ E[ p′]] − Cov[ E[ p′], π˜ ]

(A2.5) β˜ = . where A = Var[E[ p′]] – Cov[E[ p′], π̃] and B = Var[π̃]
Var[ E[ p′] − π˜ ] – Cov[E[p′], π̃]. If B = 0, then β̃ = 1. If π is constant,
then π̃ = (R – R1)p and B = Var[(R – R1)p] –
Cov[E[ p′], (R – R1)p]. In general, B ≠ 0.

1. Conditionally (that is, given the information available at the beginning of the current period), F and E[ p′] are known
constants. However, over time F and E[ p′] vary from period to period. Therefore, unconditionally, they are random
variables with nonzero variances and covariances.
2. Strictly speaking, by itself β = 1 characterizes the weak form of the expectations hypothesis. The strong form also
requires α = 0.
3. (i) Cov[a + b, c + d] = Cov[a,c] + Cov[a,d] + Cov[b,c] + Cov[b,d] and (ii) Cov[a,a] = Var[a]. If a is independent of b, then
Cov[a,b] = 0.
4. Var[a – b] = (Var[a] – Cov[a,b]) + (Var[b] – Cov[a,b]).

REFERENCES

Cornell, Bradford, and Alan C. Shapiro. 1989. The mis- Jordan, B.D., and Susan Jordan. 1997. Special repo rates:
pricing of U.S. Treasury bonds: A case study. Review of An empirical analysis. Journal of Finance 52 (December):
Financial Studies 2, no. 3:297–310. 2051–72.
Duffie, Darrell. 1989. Special repo rates. Journal of Keane, Frank. 1996. Repo rate patterns for new Treasury
Finance 2, no. 3:493–526. notes. Current Issues in Economics and Finance
(Federal Reserve Bank of New York) 2, no. 10:2–6.
Federal Reserve Bank of New York. 1998. U.S. monetary
policy and financial markets. <www.ny.frb.org/pihome/ Krishnamurthy, Arvind. Forthcoming. The bond/old-bond
addpub/monpol> (May 29, 2002). spread. Journal of Financial Economics.
———. n.d. Understanding open market operations. Stigum, Marcia. 1989. The money market. 3d ed.
<www.ny.frb.org/pihome/addpub/omo.html> (May 29, 2002). Homewood, Ill.: Dow Jones-Irwin.
Federal Reserve Bank of Richmond. 1993. Instruments of
the money market. <www.rich.frb.org/pubs/instruments>
(May 29, 2002).

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