What is a repo/reverse repo?

A repo is a repurchase transaction and it is a security that is part of the money market.

So what is a repurchase transaction? A repurchase transaction is similar to a transaction that takes place in a pawn shop. The owner of a property goes to a pawn shop and exchange it for cash but he promises to come back later to buy the property at a higher price.

Now the same goes for a repo.

1. An institution that needs cash over a short period of time goes to lender with government securities such as government bonds, treasury bills or any other financial instruments that have a high rating as collateral.

2. The lender will lend money to the borrower in exchange for the collateral. The borrower also agrees to buy back the security at a higher price at a particular time.  The difference between the two price is the profit of the lender. The time of repurchase can be from one day to a few months.If the repo transaction is greater than a month it is called a term repo. Less than a month it will be a simple repo.

3. At the agreed time the borrower buy back the collateral at the agreed higher price.

4. In case of default of the borrower the lender keep the collateral.   

You can also have what is called a reverse repo. This is the opposite of a repo. In a reverse repo the the institution will buy a security and later agree to sell the security to the seller at a higher price.

Technically the two terms are used in different circumstances but put simply if the transactions is viewed from the borrower’s perspective where the borrower will repurchase the security later it is a repo but from the lender’s perspective the lender is forced to sell the security to the borrower then it is a reverse repo.

A typical case is when banks obtain funds from the central bank. the bank is considered to be doing a repo while the central bank is considered to be doing a reverse repo.

However it is mostly large institutions that deal in repos.

What is an interest-based security?

 

There are two ways in which securities are issued. They are either issued and interest is earned on the principal, hence the term interest-based securities, or they can be issued at a discount or at a premium, hence the term discount based securities.

In this post I am going to talk about those securities that are interest-based.

When you talk about such securities the investor, you, will invest a certain amount of money called the principal. This is the amount that you would invest at the beginning of the contract and at maturity you will receive this same amount. 

Then the return every year on this amount that is invested is called the interest. The interest earned will be calculated using the interest rate on the investment. The higher the interest rate the higher the interest earned.

Hence generally this principal is invested for a length of time ranging from 7 days to five years. The interest rate of the investment also depend on the length of time for which the principal is invested. Generally the longer the time the higher the interest rate. This is because your money is locked in the investment for a longer length of time. You will thus have to be compensated for the decrease liquidity and the greater risk taken.  

Now there are two ways in which interest will be accrued on the principal. It will be either a simple interest  whereby the interest will be calculated every year on the principal alone. Hence you will obtain the same interest every year.

You can read a post on simple interest here.

The other type of interest is the compound interest  whereby the interest earned every year is calculated on the principal and the interest earned in previous years. You can read a post on compound interest  here.

What is a Banker’s Acceptance?

As we have seen in an earlier post, the Banker’s Acceptance is one of the instruments traded in the money market.

It is simply an instruments that are used by companies to obtain funds. It is generally cheaper than loans or overdraft.

Let us take the examples below to understand how it works.

A company needs money to buy goods for the Christmas season and want to obtain funds from the bank and will pay back the money after Christmas. This company generally needs to pay cash especially if it is buying goods abroad where companies do not want to take the risk to give goods on credit.

The company will approach his bank and will enter into an agreement according to the sequence below.

1. The company approach the bank to enquire about the discount rate on BAs.

2. The BA will have a face value that the company will have to pay after a specific period of time. Likewise any investor that have bought the BA on the secondary market and who will present the BA to the bank at maturity will receive the face value as indicated on the BA.

The BA will also contain the commission that the bank will take from the company. Hence the bank will pay the company the face value minus the commission. If the face value is $ 1 million and the commission of the bank is $ 20000 then the company will receive only $ 980 000. 

3. If the bank accepts this agreement it will endorse it. Hence the name of Banker’s Acceptance. If the bank has accepted the agreement it would have to pay the face value of the BA to the holder of the BA at maturity.

4. The bank will then sell the BA on the secondary market where it will be traded until it reaches maturity.

5. At maturity the company will pay back the face value of the BA to the bank. However even if this does not happen, the bank will have to pay the holder the face value.

However I would still discourage small investors from investing directly in the money market. It is much better to invest in a  money market mutual fund.

What is a commercial paper?

The commercial paper is a form of debt securities that is issued by companies. As we have seen in this post on bonds government and corporations issue bonds that have maturities of greater than one year on the capital market. With regards to maturities shorter than one year the government will issue treasury bills whereas corporations will issue commercial papers. The commercial paper will thus be, like the treasury bill, a money market instrument.

Hence the commercial paper will be issued at a discount by companies and at maturity the holder of the commercial paper will be paid the face value of the commercial paper. The discount rate will depend on the credit rating of the company and present market conditions. Since it is only companies with good credit rating that can issue commercial papers, the discount rate will slightly higher than government for treasury bills.

Companies are constantly in need of funds to settle current liabilities and to buy inventories. This is because there is always a mismatch between income and spending, The companies will thus raise the short term fund needed in the money market because use of banks for such short-term financing is costlier and time consuming.

Just like the treasury bills, commercial papers are quite safe. This is because the short-term maturities at which they are issued means that investors can determine whether the firm has a risk of default on the commercial paper. This is because investors would have known from previous financial statements whether the companies is sound and what is the possibility of it going bankrupt. However as you may know banks with their exposure to risky derivatives or bank runs may go bankrupt even if they were sound a few months or weeks before.However given the slight possibility of going bankrupt the return will be slightly higher than on treasury bills.

You might thus think that commercial papers will be good to invest in. However these commercial papers are issued at high denominations. As a result the retail investors like you cannot invest directly in them. Thus the only way to get exposure to them is through money market mutual funds.But like I have said in a previous post it would be better if you invest in stocks, government and corporate bonds and other higher yielding instruments.

Happy investing.

What are treasury bills?

Treasury bills is one type of instruments that is traded in the money market. 

A treasury bill is typically a bond that is issued by a central bank or by a government that has a maturity of less that one year. The treasury bill is sold without coupon payment. A coupon is a payment that is made every six month. It is paid as a percentage of the nominal price of the bond.Hence the treasury bill is sold at a discount and then the government will pay the face value at maturity.

These treasury bills are issued by governments in order to raise funds from the market. Because these bonds are issued by the government of a country it is therefore considered to be the safest asset and as a result would have the lowest return of all. Because of its safety it is used very often to calculate the bond spread of other bonds. The bond spread is simply the difference in return between the other bond and the return on a three month treasury bill. The greater the bond spread the riskier the bonds.

Treasury bills are also the most liquid and the most traded of all instruments. This is mainly because banks and other non-bank financial companies are required by law to hold them. For banks they may be used as collaterals in repo transactions with the central banks or in the interbank market to obtain funds. Because they are highly liquid these institutions hold them so that they can be readily converted to cash to settle obligations. Otherwise if they have excess funds they invest them in treasury bill in order to get a decent return. Short term insurers also hold a significant amount of treasury bills because they also need to have access to their fund on short notice.

These treasury bills are issued in two ways. They are either issued through auctions or over the counter. Banks and other institutions participate in weekly auctions. They state the price, the discount rate and the maturity that they want and the central banks will allocate the bills starting from the one offering the highest offered price. After they are issued in the primary market they can then be sold in the secondary market where you can buy them. However you can still buy them directly from the central bank.

As an investor you might obtain treasury bills at any institutions that have them in their portfolio and are prepared to sell them or over the counter at the central bank. But I would strongly advise investing in a money market fund if you want to gain exposure to the money market.

However since treasury bills are the safest of all investment it makes no sense investing a lot of money in them. At best you can invest 5 to 10 % in them in case you want to diversify your portfolio and decrease the riskiness of your portfolio. I would myself advise about 10% in a money market mutual fund, 10% in a bond mutual fund and the rest in other instruments such as gold, stocks, and so on.    

Some Important Factors Related To Debt Consolidation

If you wish to lower your debt burden and enjoy a single monthly payment for all your debts at a reasonable interest rate, then debt consolidation might be a helpful choice for you. It is important for you to know how you can reduce your debt with debt consolidation. The steps given below would help you get a better idea about the procedure.

• Debt consolidation is the method of combining your various debts from your different creditors into one debt, usually to one lender. There are plenty of resources where you can search for a trustworthy debt consolidation company. Locating the right debt consolidation program and company is essential to becoming successful in debt consolidation.
• Prior to researching consolidation companies, you must have a clear idea of what you’re going to do. You must precisely figure out how much you’re obliged to pay your creditors. Establish a goal of becoming debt free. Don’t make decisions in a hurry. If you have fallen into debt and shift to another location, this does not signify you can make a new beginning and resume borrowing once more. You have to change your spending habits and stress on getting out of debt. Remember you can’t become debt free by acquiring further debt.
• Know that if you go for consolidation, it might ultimately cost you more. For reducing payments, if you go for a more extended repayment term, the outcome would be paying a higher amount of interest. Once more, having the reduced payment might encourage people to assume that they have more money and they again fall into the vicious debt cycle.
• Perform some cautious research and look for inspiring anecdotes. You would obviously search for a company that provides debt counseling and the most reasonable terms and rates for debt consolidation.

Debt is not a pleasant thing but sometimes, you cannot avoid debt. Debt consolidation can be the way out for your debt problems. However, choose a company carefully and check their background with the BBB (Better Business Bureau).

What is a penny stock?

As the name suggest a penny stock that is worth pennies or is quite cheap. The definition varies but any stocks that is very cheap compared to price of solid companies may be considered as a penny stock. That compared to stocks like Microsoft that may worth hundreds of dollars. Since a stock’s price is a reflection of the future earnings of the company then in theory a penny stock is the stock of a company whose earning’s prospect is quite tiny to be respectful.

So what is the fuss you may ask. The penny stocks is composed of two types:

1. The first group of stocks is made up of the stocks of companies that that are going out of business. Think of a company of  camera with reels, a magnetic tape company, or a company that makes floppy disks, etc. These companies may once have been mighty, but their products are now obsolete or their business model have failed and as a result they will certainly go out of business unless they reform or restructure. So any stocks of these companies is throwing money out of the window.

2. The second groups consist of tiny companies that have just started up but do not have the recognition of the bankers. So they are craving for you to give them the chance  that they need. Think of Microsoft or apple in the 70s.However you also know that 90% of small businesses will go out of business in the next 2 years. So it is still quite difficult to spot the company that will make it big.

Now that you have understood what penny stock is you can see that it is quite risky to invest in them but if you are able to spot the one then you can multiply you money by a lot.

 

Let us look at the factors that makes these stocks risky.

1. These stocks are generally not listed on an exchange. This may be because to list on an exchange a company have to abide to some strict conditions such as financial reporting guidelines, directors have to abide to some rules, etc. If these companies cannot abide to these rules that are there to protect shareholders or other stakeholders, then it is not a good idea to invest in them. Financial statements will enable you to analyse the company’s performance other several years and see if they are worthy of your money. The companies may be run by convicted directors. Companies run by convicted companies will not be allowed to list on exchanges and if they are not listed on exchanges they will not provide reports and as a result you will not know about the directors. As you can see there are a lot of risks.

2.If you have bought these stocks then someone out there may be thanking all the gods of the earth. You do not get an idiot everyday to buy a stocks that no one want. This is because penny stocks are illiquid that is they are difficult to sell. There are a lot of sellers but a few buyers. The only way people can sell their penny stocks is only if someone is foolish enough to buy it.

3. These stocks are easily manipulated by fraudsters. Since they are illiquid and hard to sell, some people buy them cheaply and then make a hype about the stock so that unsuspecting buyers will but them at a higher price.

As you can see it is quite risky to buy these types of stocks. Although you would make it big if you can buy in the next apple or the next Microsoft it is more likely that you will lose your money. So just like I advise investors to avoid derivatives, I would advise them to avoid penny stocks. Invest in healthy companies. Also if a listed companies is delisted or is about to delisted get out immediately.

Good luck to you all in your investing.