What is a Repurchase Agreement?
A repurchase agreement or a repo is an interim borrowing for dealers in overall government securities. In a repurchase agreement (repo), a dealer, on an overnight basis, sells government securities to the investors and then repurchases them the subsequent day at a slightly higher price. The minor price difference is called the implicit overnight repo rate. It is a Repo for the party selling the security in order to repurchase it later; for the one who is buying the security and then agreeing to sell, is undertaking a reverse repurchase agreement. Repos are majorly used to:
- Build short-term capital
- As a tool for central bank open market operations.
Now that we have an idea about what is a repurchase agreement and also a basic repo market definition, let us look further into its components and types. These details and formulas will help you better understand repo loans.
Components
A Repurchase agreement is often branded to be a money market instrument. The repo market functions as a short-term, collateralized loan with implied interest. The buyer is like some short-term lender who sells the securities as collateral. On the other hand, the seller becomes a short-term borrower. Therefore, for the entire transaction, fluidity, trust, and liquidity are highly valued in the repo market.
You as an individual are likely to use a repurchase agreement in order to fund the purchase of debt securities, loans, or other similar investments. The Federal Reserve flow into the re-purchase agreements in order to normalize the supply of money and bank reserves. Repurchase agreements are investments that are strictly short-term. The maturity period of the repurchase agreement is known as the “rate,” the “term” or the “tenor.” It is very common to think of a repurchase agreement to be a loan for bank payments or income tax purposes. But repos are special in the following two ways:
- If investors go bankrupt, then in the case of a repurchase agreement, they can sell their collateral.
- Most collateralized loans provide an automatic stay for bankrupt investors.
What is Repo Rate?
Let us now understand how the repurchase agreement as a process matures and reflects interests and gains over time. If you want to secure the costs and benefits of a repurchase agreement you need to consider three different calculations:
1) Cash paid during the first security sale
2) Cash paid for security repurchase
3) Implied interest or repo rate
So, we learn how cash is paid twice in the complete process of the repurchase agreement. However, the cash paid in the first security sale and the cash paid for the security repurchase depends chiefly upon the type of security implied in the agreement and also its value. Hence, the implied rate of interest, that is, the repo rate, becomes a significant calculation. Here’s the formula so that you can calculate it yourself:
- Repo rate/Interest rate = [(future value/present value) – 1] x year/number of days between two legs
Considering risk factors, repos with lengthier tenors are at higher risk. Longer tenors are bad for repurchaser creditworthiness and repo rate can fluctuate more frequently, harming the repurchased asset value. If the repo rate turns out to be unfavorable, a repurchase agreement will then not be a good way to gain some short-term cash. The major difference between a term and an open repo lies in the amount of time between the sale and the repurchase of the securities.
The different types
Now that we know what are repurchase agreements let’s look further into their different types
- Third-party repo (tri-party repo) – a bank or a clearing agent protects the interests by conducting businesses between the buyer and seller
- Specialized delivery repo – transactions with bond guarantee during the repurchase agreement
- Held-in-custody repo – cash received by the seller upon selling the security, held in a custodial account for the buyer.
The above details about the Repurchase Agreement will surely give an insight into the answers to some of the most sought questions.
Further Reading
