Repurchase agreement is commonly known as ‘repo’ or repurchase and sale agreement. It refers to sale of securities with an agreement that the seller will be able to buy those securities back in the future. In this regard, the repurchase price ought to be great than the original selling price. The difference represents the interest which is known as repo interest. The party buying the securities originally is known as the lender while the original seller is the borrower because they use their security to acquire a secured loan at an interest rate that is fixed.
For instance, trader B may sell security to trader C at a set price and make the agreement to buy it back at a specific amount in future. In actuality, the sale isn’t real rather, it is a loan that is secured by security. As is the case with collateralized loans the security in this case is used as collateral which is held by trader C in the event trader B defaults on payment. Incremental amount repaid by trader B is the interest on the loan offered by trader C.
Repurchase agreement is a short time transaction that mostly comes with overnight terms though there are others that extend for a couple of years. Short term repos have low risks compared to long term ones which are prone to market fluctuations.
Repurchase agreement has grown to cover a large section of the money markets while at the same time fuelling short term markets growth for mutual funds in the trade of securities that are government backed like T-bills. In actual sense the largest purchaser of repos is the Treasury through the Federal Reserve Bank system which in turn provides essential short term liquidity for traders.
For a buyer, a repo provides the opportunity to make cash investment for a customized duration. A repo is a safer and short term secure investment since investors receive collateral. For traders who are in trading firms, repurchase agreements are used for purposes of financing long positions, obtaining access to funding costs that are cheaper and covering short securities positions.
Apart from use of repo as a fund vehicle, the traders also ‘make markets’. Such traders are known traditionally as “matched-book repo traders”. The concept of such traders follows that of brokers who participate in both sides of any active trade and they essentially don’t have any market risk but rather, credit risk only.
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