Repos and risk

Arguably one of the most popular investment products in Jamaica – the “repo”. Why do Jamaicans love repos so much? Like most people we all prefer to park our money somewhere and know that we can come back to it in 30 days, 90 days, 180 days or 1 year and see the exact same amount PLUS some interest. No price fluctuations, no excuses, just what you put in plus what you earned, simple. People generally view repos as low risk because of the stability of the returns. While returns are stable – repos carry risk, and you should know how they work.

• What is a repo? “Repo” is short for “repurchase agreement”. You are buying an asset from your broker and they are committing to repurchase the asset from you at a specific date in the future. For the period of ownership – you get a share of the return that the asset generates – often quoted as the interest rate. In other words – you actually own this asset briefly. This asset is usually, a bond or fixed income instrument. If you do not like bonds – then technically, you may not like repos, since bonds quite often secure the repos you invest in.
• What determines the risk of a repo? The risk of your repo is determined primarily by the “reliability” of the broker’s promise to repurchase it from you at the end of the period. However, the risk level is also affected by the quality of the underlying asset that you briefly own. You should be confident that the broker can honour their promise to repurchase the asset.
• Why should you care about the quality of the asset? If the broker commits to buying it back from you, why should you be concerned about the quality of the asset? In instances where the broker cannot repurchase the asset from an investor at maturity of the repo, the investor will have to sell the underlying asset to recoup their investment. Therefore, you should also have a reasonable degree of confidence that the underlying asset itself is sufficiently liquid and creditworthy. 
• Why do the interest rates vary? High risk assets will offer higher repo rates, and lower risk assets will offer lower rates. Longer dated bonds will usually have higher yields than shorter dated bonds. As a result, repos with longer tenors tend to have higher rates than repos with shorter tenors.

Repos are more complex than they seem. The mechanics can vary across markets and brokers. Investors should understand how they work and the types of risk they are facing. This will allow the investor to determine if he/she is being adequately compensated for the risk being assumed.

Marian Ross is Vice President, Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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