We develop a general equilibrium model which integrates the term structure of interest rates and the repo market to shed light on the effects of demand pressure on special repo rates, the rates for borrowing money in transactions collateralized by the most sought-after bonds. In our model, investors with habitat preferences for special bonds exert a significant degree of price pressure in the secondary market. Arbitrageurs take the opposite side, but finance their positions by rolling over repo contracts, thus increasing the specialness of the targeted securities. The demand pressure is reflected in lower repo rates to borrow against these bonds. We characterize in closed form the endogenous dynamic interaction between bonds and repo rates, and illustrate both the strong localization of supply effects and the resulting portfolio rebalancing of investors. Our calibrated model can quantitatively match US Treasury data and the coexistence of general and special bonds in the yield curve. The requisite absence of arbitrage opportunities between bonds with equivalent cash flows achieves as the expected risk-return ratio accounts for the short repo rates, which vary at the instrument level.
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