Repo is a short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often Treasury securities. A contract in which the seller of securities agrees to buy them back at a specified time and price also called repurchase agreement or buyback. On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds. Securities dealers are the major borrowers in repurchase agreements or repos. This is because it is the cheapest form of financing. Repos are classified as a money-market instrument. They are usually used to raise short-term capital.
In a simple example of repo, the party sells a security to another and agrees to repurchase it at a later date. The first party, the borrower, gets cash and the second party, the lender, earns a return equal to the difference between the price at which he buys the security and the price at which he resells it. In common parlance, the seller of securities does a repo and the lender of funds does a reverse. Because money is the more liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value, usually by 2 to 5 percent depending on maturity. To finance their operations, dealers borrow against their inventories of securities. Extremely high profits can be generated when prices rise, but devastating losses can be generated when prices fall. Repos can be of any duration but are most commonly overnight loans. Most repos are overnight transactions, with the sale taking place one day and being reversed the next day. A repurchase agreement or repo can summaries mean by which is an agreement between two parties whereby one party sells the other a security at a specified price with a commitment to buy the security back at a later date for another specified price.
While a repo is legally the sale and subsequent repurchase of a security, its economic effect is that of a secured loan. Economically, the party purchasing the security makes funds available to the seller and holds the security as collateral. If the repo security pays a dividend, coupon or partial redemptions during the repo, this is returned to the original owner. The difference between the sale and repurchase prices paid for the security represents interest on the loan. Indeed, repos are quoted as interest rates. Securities dealers use repos to finance their securities inventories. They repo on their inventories, rolling the repos from one day to the next. Counterparties may be institutions, such as money market funds, which have short-term funds to invest, or they may be parties who wish to briefly obtain use of a particular security. For example, a party may want to sell the security short, or they may need to deliver the security to settle a trade with another party.
Repurchase agreements which are sale-repurchase agreements, reversing out, to repo securities, to sell collateral, and buybacks are agreements between a borrower and a lender where the borrower, in effect, sells securities to the lender with the stipulation that the securities will be repurchased on a specified date and at a specified, higher price. The price at which an asset is repurchased in a repo is equal to the price at which it was sold plus an amount of interest for the use of the cash. The amount of interest is calculated from a market-determined interest rate called the repo rate. The securities serve as collateral for the loan. The difference between the repurchase price and the amount loaned is the amount of interest paid by the borrower to the lender, which is found by the following formula:
Dollar Interest = Principal x Repo Rate x (Repo Term in days/360 days)
The repo rate is the annualized interest rate of the transaction:
Repo Rate = Dollar Interest/Principal x 360/ (Repo Term in days)
Sometimes margin must be posted, where the amount of the loan is slightly less than the worth of the collateralized securities, also known as a haircut. This helps to protect the lender from the possibility that rising interest rates will reduce the value of the collateral. Most repo agreements mark the collateral to market daily. Repo in government securities are fully-assigned, with collateral securities identified at the initiation of the trade.
Repo proceeds include accrued interests. Typically repos are conducted as 'classic repos' with both initial and variation margin applied on market values of collateral securities. Variation margin may be called when the fall in value of collateral securities exceeds a mutually agreed margin threshold. If the value of the collateral drops below the required margin, then the borrower may be subject to a margin call, or the repo may be re-priced in which the value of the loan is reduced. In either case, the borrower must send more money to the lender to maintain margin or to reduce the principal outstanding.
The main benefit of repos to borrowers is that the repo rate is less than borrowing from a bank. The main benefit to lenders over other money market instruments, such as commercial paper, is that the maturity of the repo can be precisely tailored to the lender's needs.
Major borrowers include large banks, and also dealers in banker’s acceptances. Government securities are the main collateral for most repos, mortgage-backed securities, and other money market instruments.
The Repo Market
The repo market is the largest money market sector. The repo market is one in which two participants agree that one will sell securities to another and make a commitment to repurchase equivalent securities on a future specified date, or on call, at a specified price. There are several other large traders of repos besides government bond dealers. The net buyers of repos are money market funds, bank trust departments, municipalities, and corporations. The net sellers of collateral are thrifts and commercial banks. In effect, it is a way of borrowing or lending stock for cash, with the stock serving as collateral.
Repos are not only used to finance inventory, but are also used to cover short positions of securities, and much of the repo market arises from speculative trading, where traders attempt to profit from the differences in the repo rates of repos and reverses.
