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Problem_Set_2_solutions

# Problem_Set_2_solutions - Concept Market Brokers Block...

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ECO V3265 Perry Mehrling Fall 2006 Problem Set #2—Repo Math (due Friday Oct 5, 4pm, Lehman 4a) 1. Security Dealers. Table III at http://www.newyorkfed.org/markets/statistics/deal.pdf shows the positions of primary dealers, and Table IV shows how they finance those positions. In lecture 7 we saw how security dealers could be viewed as a kind of bank, with overnight RP borrowing analogous to a demand deposit, and term reverse lending analogous to a bank loan. a) Suppose that one of the dealer’s RP clients declines to renew the RP for another day because the client needs the money to make a payment, so the dealer faces the problem of a reserve drain. By analogy to the interbank Fed Funds market, consider how the dealer might use the interdealer RP market to raise the needed funds. The dealer can replace the RP loan “called in” by his client with an RP loan from another dealer. This is similar to a situation where a Bank faces low reserves because its customer (depositers) are withdrawing deposits and must take a loan from another bank in order to replenish reserves. b) Suppose that the interdealer RP market doesn’t solve the problem (because the ultimate recipient of the payment does not invest in RP). By analogy to the discount window, consider how the dealer might use his clearing bank to raise the needed funds. Where does the bank get the funds? The dealer could take a loan from his clearing bank at the “dealer rate,” a rate that represents a significant penalty compared to the rate of RP’s. This penalty corresponds the penalty banks face when they use the discount window. c) Consider now a third alternative, that the dealer declines to renew a term reverse loan that is maturing. Using balance sheets, trace how in this case the reverse client pays the dealer who pays the RP client, and the dealer’s balance sheet shrinks on both sides. Stage 1: before transactions. Stage 2: Reverse Client repays RP loan from Dealer. Stage 3: Dealer repays RP loan from RP client. This balance sheet uses the “loan” representation of a repo. What would change if we represented the repo as a “matched sale?” Reverse Client (#1) Dealer RP client (#2) Money RP Loan f. Dlr RP Loan (#1) RP Loan (#2) RP loan to Dlr -Money - RP Loan f. Dlr +Money -RP Loan (#1) -Money -RP loan (#2) +Money - RP loan to Dlr

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ECO V3265 Perry Mehrling Fall 2006 d) Usually the dealer prefers the first solution to the second, because RP is usually a cheaper source of funds. Why does the dealer usually prefer both the first and second alternative to the third? The dealer makes money by borrowing at a low rate and lending at a higher rate, so
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Problem_Set_2_solutions - Concept Market Brokers Block...

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