Definition
A Repurchase Agreement, commonly referred to as a “repo”, is a form of short-term borrowing for dealers in government securities. In this agreement, the dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. The difference between the selling price and the repurchase price is the actual interest on the loan.
Key Takeaways
- A Repurchase Agreement (also known as a repo) is a short-term borrowing technique for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.
- For the party selling the security (and agreeing to repurchase it in the future) it’s a repo; for the party on the other end of the transaction (buying the security and agreeing to sell in the future) it’s a reverse repurchase agreement.
- Repurchase Agreements are generally considered safe investments because the security in question functions as collateral, which is why most agreements involve U.S. Treasury bonds. However, the actions taken by the seller at the end of the contract’s term are dependent on the seller’s financial situation and could pose a risk to the buyer.
Importance
A Repurchase Agreement, often called a Repo, is significant in finance because it’s a form of short-term borrowing, typically used by dealers in government securities. It is essentially a contract where a seller sells a security with the promise to buy it back at a specific time and price.
This is important as it provides liquidity, acts as a tool for money management and impacts the general level of interest rates. Since governments, banks, hedge funds, and other institutions handle large sums of funds, these agreements are crucial for managing temporary cash needs.
Furthermore, the Federal Reserve uses repos to conduct monetary policy when they wish to increase the money supply in the target economy to stimulate economic activities. Hence, understanding repurchase agreements is important for comprehending the functioning of financial markets and institutions.
Explanation
A repurchase agreement, commonly referred to as a repo, serves as a short-term borrowing method typically used by government securities dealers. The purpose of this financial instrument is to raise immediate capital.
In essence, the agreement involves selling a security – usually a Treasury bill or a bond – to an investor, and then buying it back after a specified period, which can range from a day to a few months. The difference between the security’s initial selling price and its higher repurchase price translates into a loan’s interest.
Repurchase agreements are a cornerstone of money markets, providing a virtually risk-free, albeit temporary, investment option. The interest rate on a repo, known as the repo rate, tends to be lower than other short-term borrowing rates because of the high security of the transaction.
Repos are used by central banks to implement monetary policies, manipulate the money supply, and control interest rates. In the financial markets, entities like mutual funds, insurance companies, and pension funds use repurchase agreements to make short-term investments or to cover short positions in specific securities.
Examples of Repurchase Agreement
Central Banks and Commercial Banks: One of the most common real-world uses of repurchase agreements is made by Central Banks like the Federal Reserve in the U.S. When a Central Bank wants to increase the money supply in the economy, it can enter into a repurchase agreement with commercial banks. Central Bank buys securities (like government bonds) from the commercial banks and agrees to sell them back at a later date. This means the Central Bank is injecting money into the economy in the short term.
Pension Funds and Investment Firms: A pension fund may hold a large amount of securities (like bonds) that a hedge fund is interested in. Instead of selling on the open market, the two can agree on a repo transaction where the hedge fund obtains the securities it needs while the pension fund still essentially maintains its long term position.
Financial Institutions Overnight Borrowing: Financial institutions often use repurchase agreements for short-term borrowing purposes. It’s similar to a loan where the financial institution sells its securities to another company with the agreement of buying them back the next day. The other party gets cash and the promise they’ll sell back the securities the next day at a slightly higher price, giving them a small profit. This is often referred to as an “overnight repo”.
FAQ: Repurchase Agreement
1. What is a Repurchase Agreement?
A Repurchase Agreement (also known as Repo) is a short-term agreement to sell securities in order to buy them back at a slightly higher price. These agreements are essentially short-term loan alternatives usually dealing with government securities.
2. How does a Repurchase Agreement work?
In a Repurchase Agreement, one party initially sells some quantities of securities to the other party and agrees to repurchase the same quantities of securities at a specific future date and price. The selling party is getting a short-term loan with the securities as a collateral, and the buying party will earn interest.
3. What is the purpose of a Repurchase Agreement?
Repurchase Agreements are primarily used for short-term financing purposes. Banks, government authorities, financial institutions, and money market funds are common users of Repurchase Agreements. They are a way of borrowing money for short periods of time, typically overnight.
4. What is the risk associated with a Repurchase Agreement?
The risk associated with Repurchase Agreements is relatively low, but defaults can happen. The Main risk is that the seller may default on their obligation to repurchase the securities. There is also the risk of the value of the underlying security decreasing below the agreed repurchase price.
5. How are Repurchase Agreements regulated?
Repurchase Agreements are heavily regulated due to their critical role in the global financial system. The Federal Reserve, Office of the Comptroller of the Currency (OCC), and the Securities and Exchange Commission (SEC) are among the US regulatory authorities overseeing Repurchase Agreements.
Related Entrepreneurship Terms
- Collateral
- Liquidity
- Short-term Financing
- Securities lending
- Reverse Repurchase Agreement
Sources for More Information
- Investopedia – A leading source of financial content on the web, ranging from market news to retirement strategies, investing education to insights from advisors.
- Federal Reserve – The central bank of the United States provides the nation with a safe, flexible, and stable monetary and financial system.
- Bank for International Settlements – An international financial organization serving as a bank for central banks. It provides a range of services to central banks and other official monetary institutions.
- SIFMA (Securities Industry and Financial Markets Association) – Representing the industry’s interests on legislative and regulatory issues on a global scale, it provides insights, data and analysis across all Fixed Income, Equity, and Derivatives markets.
