1. Assume that a hedge funds uses $100,000,000 of US Treasury bonds to borrow $98,000,000 from a bank via an overnight repurchase agreement. The hedge fund is obliged to pay back $98,002,685 on the next day.

a. What is the interest rate on this repo? (Hint: multiply the rate that you get by 365 days to get an annual rate of interest.)

b. What is the haircut on this repo?

2. Repo Dynamics
a. Use balance sheets to represent an initial situation in which the government has issued bonds to invest in infrastructure and an investor has purchased the bonds (without borrowing). Show the balance sheets of the government and of the
investor.

b. Now introduce repo: assume that the investor is a hedge fund that invests in the bonds because it knows it can borrow against them using bank repos. Show the balance sheet of the government, of the hedge fund and of the bank. (For now assume the hedge fund just holds the deposits from the repo.)

c. Now assume the hedge fund uses the money raised on repo to buy private sector bonds. Show the balance sheet of the government, of the hedge fund, of the bank, and of the private sector bond issuer.

d. In early 2007 repo was used to finance both private and government bonds and haircuts on many bonds, including privately issued bonds, were zero. Use the balance sheets in part c and what you know about banking to explain how the repo market could facilitate the development of a positive feedback loop that drives prices up on securities markets.

e. What happens to this system if there is a shock that causes bond prices to fall? Explain clearly and step by step how this can set off a negative feedback loop that drives prices down.