Repurchase Agreement (Repo)

A Repo or repurchase agreement stands for the sale of some security, stipulating that the seller has to buy it back from the buyer at a higher price and at a later date. The price goes up at maturity because of the added interest, calculated on the basis of the repo rate set in the contract.

How the Repos Work

A repo employs the same concept as that of a secured loan. In repurchase agreements, a person sells some security in exchange for a sum of money. The seller transfers the ownership of the security, buying it back within 30 days. In this event, the seller becomes a borrower and the buyer plays the role of a lender. During the transaction, the security serves as the collateral securing the loan.

Repos involve a low level of risk for the buyer and seller because the purchased securities are typically very liquid. In the event the seller defaults on his obligations, the buyer has the right to sell the security or use it to gain profit. The security involved in the transaction can be of any kind: a share in company's assets, bonds, treasury bills, or another financial instrument. Because the transaction comes with a short term maturity, it can be a profitable investment tool for many investors on the money market.

It can be noted that repurchase agreements stand for a combination of forward contract and cash transaction. The money transfer element, in exchange for the security's legal transfer, is the cash transaction. The forward contract, on the other hand, ensures the loan repayment and the return of the collateral. The loan interest is the difference between forward and spot price, with the settlement date being the loan's maturity date.

Reverse Repo

While a repo is initiated by the owner of the security, borrowing money against collateral, a reverse repo stands for the opposite. Simply put, this is the transaction from the buyers view point. While a seller considers the agreement a repo, it as a reverse repo for the buyer. The latter is one option for investors to make good money because government, business, and other entities in the US seek ways to borrow money - one of these is selling securities in the form of repos.

Term Repo

In contrast to the repo, a term one takes longer to mature. With this kind of agreement, a larger amount of money is involved, thus requiring more time to repay. During the period between the sale and repurchase, the seller cannot use the security in any way. The buyer, as the current holder of the security, may use it as he seems fit. During that time, the seller has to pay for the principal and interest calculated accordingly. After the repurchase is completed, the seller is free to use the security.

In addition, when the underlying security of a repurchase agreement is corporate or government bonds, it is referred to as equity repo.

Trading firms finance long positions through repurchase agreements, gaining access to other speculative investments and covering short positions. Furthermore, repo traders make profits from the bid and ask spreads, i.e. between the reverse and repo rate. Traders make use of various strategies such as liquidity management, collateral swaps, and non-matched maturities.