Repurchase Agreement (Repo)
March 12, 2025
What are Repurchase Agreements?
Repurchase agreements, or repos, are short-term borrowing tools where one party sells securities to another with an agreement to repurchase them at a higher price at a later date. Repos are typically overnight transactions using government bonds to provide liquidity in the money markets. The difference between the sale price and the repurchase price represents the interest paid on the loan.
Key Learning Points
- Repurchase Agreements (Repos) are short-term borrowing tools where one party sells securities to another with an agreement to repurchase them at a higher price at an agreed later date
- They are commonly used in money markets to provide liquidity and secure financing
- There are various types of repurchase agreements, including overnight repos, term repos, and open repos.
- Each type has different terms and conditions regarding the duration and interest rates
Why is Repo Important?
Repo financing plays a critical role in the financial system.
Repo Diagram
This diagram shows how repos may be used to provide liquidity in money markets.
Repos provide market participants with access to low-cost, secured financing to purchase securities. For example, market makers in government bonds who have just bought government bonds from clients will often fund these positions in the repo market, acting as the repo party. They borrow money using repos and buy government bonds from other investors. This allows them to finance their positions at a low cost by providing bonds as collateral in exchange for cash.
However, market makers also frequently take the position of the reverse repo party. For instance, if they sell bonds to a client but don’t currently hold those bonds in inventory, they might source the bonds in the repo market to deliver them to the buyer. In this case, the market maker would borrow the bonds through a reverse repo transaction to fulfil their delivery obligations.
This shows that a well-functioning repo market is essential for bond market makers, as it enables them to efficiently manage their positions and inventory. But the repo market is not just important for market makers.
Significance of the Repo Rate
The repo rate is the agreed-upon interest rate that the borrower pays on the cash provided in a repurchase agreement.
The repo rate is significant because it provides market participants with access to low-cost, secured financing to purchase securities. This rate is crucial for maintaining liquidity in the financial markets and is influenced by market liquidity and expectations for future interest rates.
Repurchase Agreement (Repos) Example
An example of a repurchase agreement involves a borrower selling government bonds worth $100 million to a lender and agreeing to repurchase them at $102 million after a specified period. The $2 million difference represents the interest paid by the borrower.
Access a free Financial Edge template from the free downloads section which will walk through the steps required to calculate repo interest on a real example.
Key Repurchase and Reverse Repo Agreement Terms
Repurchase agreements (repos) involve a cash borrower and a cash provider engaging in a transaction where bonds are used as collateral. The process includes the inception of the agreement, the exchange of collateral and cash, and the maturity of the repo. The terms can vary based on whether the repo is overnight or term, with term repos typically having a higher rate.
Difference Between Repurchase and Reverse Repo Agreements
In a repurchase agreement, the seller (borrower) agrees to repurchase the securities at a higher price. In a reverse repo, the buyer (lender) agrees to sell the securities back to the borrower at a higher price. Essentially, a reverse repo is the mirror image of a repo transaction.
Factors Affecting the Repo Rate
The repo rate is influenced by several factors, including the credit quality of the collateral and the supply and demand dynamics. Repos are collateralized, which reduces the lender’s risk. The spread between the unsecured borrowing rate and the repo rate is driven by these factors.
Term vs. Open Repurchase Agreements
Term repos have a fixed end date or maturity date, while open repos do not have a specified end date and can be terminated by either party at any time.
Types of Repurchase Agreements
There are various types of repurchase agreements, including overnight repos, term repos, and open repos. Each type has different terms and conditions regarding the duration and interest rates.
- General Collateral (GC): this type of repo typically has one repo rate for all government bonds from the same issuer and reflects the general market demand for cash.
- Special Collateral (Special): this type of repo involves specific securities that are in high demand, leading to a lower repo rate compared to general collateral.
Near and Far Legs
In a repurchase agreement, the transaction consists of two legs:
- Near Leg: this is the initial transaction where the seller sells the securities to the buyer and receives cash in return.
- Far Leg: this is the subsequent transaction where the seller repurchases the securities from the buyer at a predetermined price.
Key Repurchase and Reverse Repo Agreement Terms
Some key terms in repurchase and reverse repo agreements include:
- Initial Margin Agreement: the initial margin is the percentage of the collateral’s market value that must be maintained throughout the repo term.
- Collateral Selection and Transfer: the process of selecting and transferring the securities used as collateral.
- Daily Valuation and Margin Call: the daily valuation of the collateral and the process of issuing margin calls if the collateral’s value drops.
- Collateral Substitution: the ability to replace the existing collateral with new securities.
- Conclusion of Repo: the final step where the repo transaction is concluded, and the securities are returned to the seller.
Repo Rate
The repo rate is the interest rate that the borrower pays in a repurchase agreement. It is influenced by factors such as the credit quality of the collateral, supply and demand dynamics, and market liquidity.
Risks of Repo
The risks associated with repos include counterparty risk, where one party may default on the agreement. It also includes market risk, where the value of the collateral may fluctuate according to macro-economic conditions.
- Credit Risk: the risk that the collateral may not fully cover the loaned cash, creating credit risk for the cash lender
- Market Risk: the risk that the collateral’s market value may drop significantly during the repo term, leading to potential losses
- Liquidity Risk: the risk that the collateral may not be easily liquidated in the market
Conclusion
Repurchase agreements (repos) are essential short-term borrowing tools that provide liquidity and secure financing in money markets. Understanding the various types, key terms, and associated risks of repos is crucial for effectively utilizing them in financial operations.