Institutional investors tend to finance their purchases in two ways instead of purchasing securities outright. They are:

  • Buying on Margin - In this form of financing the buyer borrows funds from a broker/dealer who in turn gets the cash from a bank. The institution is charged an interest rate plus some additional charges for using this method. Regulations T and U, as well as the Securities Act of 1934, limit the degree to which the margin can be extended to the buyer.
  • Repurchase Agreements - These are collateralized loans in which the institution sells a security with the commitment to purchase the same security at a later date. The length of time could be as short as overnight or extend all the way to the maturity of the security. The price that is agreed upon is the repurchase price and the institution is charged a repo rate. The repo rate is an implied interest rate, which is the cost that the institution incurs for funding the position. Its benefit is that it is a very cheap way to finance a position because the repo rate tends to be set around the Federal Funds rate.

Interest Rate Risk

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