Handling Coupon Payments
- 03:35
Describes how the holder of the collateral/bond receives the coupon, but an adjustment is needed for the borrower to receive the benefit.
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Transcript
Let's talk about how coupon payments are handled in a repo transaction.
In general, coupon payments go to the legal holder of the securities at the time the coupon is paid.
If the coupon payments occurs during a repo transaction, this is the cash lender, also known as the reverse repo party.
This is because in a standard repo transaction, the ownership of the securities is legally transferred to the cash lender for the duration of the repo period, even though it's a temporary transfer.
And as the legal holder, the cash lender who temporarily holds the securities as collateral receives any coupon payments made during this time.
However, because the original owner, the cash borrower still retains economic interest in securities.
It's only fair that they benefit from any income generated by the security such as coupon payments.
To maintain this fairness, there's an adjustment mechanism in place to ensure that the cash borrower, who is the original owner of their securities, effectively retains the economic benefit of the coupon.
This adjustment can be made in a couple of ways.
One option is to adjust the repo interest rate downwards.
By lowering the rates, the lender effectively compensates the borrower, the original security holder for the coupon income they miss out on.
However, this approach is less common.
A more common approach is to adjust the repurchase price to reflect the coupon payments.
Here's how it works. Imagine you as the cash borrower and original security owner enter into a repo transaction with a cash lender.
During the repo term, a coupon payment is made on the security.
Since the cash lender holds the security, they receive the coupon. To ensure you still get the economic value of this coupon, the repurchase price, the price you'll buy back the security at the end of the repo is reduced by the coupon amount.
So if the repurchase price was initially set at 100% and a coupon payment of 2% is made during the repo period, the adjusted repurchase price would then be 98%. This way, although the lender received the coupon payment directly, the economic benefits effectively returns to you by lowering the amounts you have to pay to repurchase the security.
This adjustment process ensures that the income generated by the security during the repo period.
In this case, the coupon still benefits the original owner maintaining the economic equivalent of holding the security outright.