• Repurchase Agreements – Repo

    Repurchase agreement also known as Repo in financial industry is an agreement between the repo seller to take a loan on the collateral security and to buy-back the collateral after a pre-specified duration or at a pre-specified date. In this agreement, the holder of the security (mainly government security, treasury bills, stocks, bonds, loans etc) makes an agreement to sell the security to a lender and to buy back the security at a later date. The lender earns on the amount of the difference between the buying price and selling price which is effectively named as the interest or coupon rate.

    In this deal, the buyer holds the security as collateral and can sell the security if the seller is unable to repurchase the security at maturity. This collateralized security makes the repurchase transaction a secure transaction with lower credit risk.

    Types of Repo:

    Based on maturity, there are two types of Repo rates which are term and open repo. A term repo has a term date specified while open repo rate does not contain end date.

    Repo transactions can also be classified based on their holding pattern as, which are specified, tri-party and held-in custody.

    • Specified: requires the delivery of a pre-specified security at the beginning and at the maturity of the transaction period.
    • Held-in Custody: here security is held by the seller during the term of the agreement. If the seller of the security becomes bankrupt during the tenure of the agreement, then the buyer can use the collateral security to recover his investments.
    • Tri-party: In this case, a third party, an agent or collateral party, acts as an intermediary between the seller and the buyer. The third party agrees to hold the security during the tenure of the agreement and processes the payment between the buyer and the seller.

    Reverse Repo: A reverse repo is the same repurchase agreement but the only difference is that it is from a buyer’s point of view. In this transaction, the buyer sells the security which it bought from other seller in the market. At the maturity of the original repo transaction, the buyer will purchase the security from the market and return it to the seller.

    How repurchase agreement benefits both seller and buyer:

    • Benefit to seller – A seller may need immediate cash or liquidity but only for a short duration of time, so it is not advisable to sell government security or other holdings to generate cash. Also selling security holdings is more time consuming and requires more due diligence to get proper price. Here the seller can enter into repo agreement with a buyer or financial institution using the securities as collateral to fund its immediate cash need.
    • Benefits to buyer – A financial institution such as bank, investment fund, etc. may have idle liquid cash available but does not have any immediate requirement. It can use the idle cash to invest in such agreements to get some return. Also these investments are safe as the buyer holds the security as collateral.

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