What is a Repurchase Agreement?
A repurchase agreement (or repo for short) is a type of short-term borrowing for dealers who deal in government securities. Within this agreement, the dealer sells government securities to investors. Once sold, they repurchase the securities at a higher price. This transaction takes place within a short period of time. Likewise, it usually takes a day or two at most.
The premium that dealers pay for these securities is due to the implicit interest rate on them for the sale period. For dealers, repurchase agreements are a way to finance their short-term needs. Similarly, repos are prevalent in central bank open market options.
There are two sides to repurchase agreements. The first side is the dealer who sells securities and repurchases them later. For the dealer, this transaction is a repurchase agreement. The second party is investors who buy these securities and agree to sell them later. For these investors, the transaction represents a reverse repurchase agreement.
How does Repurchase Agreement work?
While repurchase agreements are essentially loan transactions, they include the sale and repurchase of securities. Usually, these include government securities. However, companies may also use repurchase agreements to raise immediate finance. Repurchase agreements are classified as a money market instrument and are a way for entities to get funds.
A repurchase agreement starts from a dealer. As mentioned, this dealer can be any party offering any security. However, these usually involve US treasury bonds and other government securities. When the dealer wants to gain immediate finance, they can’t go for most other finance sources. Therefore, they may choose to sell their securities through a repurchase agreement.
When the investor agrees to purchase those securities, they enter into an agreement with the dealer. Within this agreement, the dealer agrees to sell the securities and repurchase them shortly. The investor also agrees to hold the securities until the agreed-upon date. Once the date arrives, the investor can resell the securities to the dealer. The dealer usually pays a premium for the repurchase. Therefore, the investor benefits from this transaction.
According to the agreement, the seller cannot sell the securities to any other parties until the agreed-upon date. Therefore, the transaction becomes loan provision or financing rather than a sale and purchase transaction. In a repo transaction, the underlying securities act as collateral for the finance. The dealer pays a premium that is the interest payment on the securities for the time the investor holds them.
What are the risks associated with Repurchase Agreements?
Repurchase agreements are usually secure transactions for investors. However, there is still a risk that the dealer or seller fails to repay the finance amount. It represents a credit risk for the seller. The risk is high as repurchase agreements indicate cash flow or finance problems for the seller. However, since the securities act as collateral in the transaction, buyers can recover their paid amount.
However, the value of the underlying securities may decline during the time that the seller holds it. Therefore, sellers may not recover the same amount they paid for the loan. However, there’s also a chance that the market value of the securities may increase. Therefore, buyers may not resell them to the dealer. Overall, repurchase agreements can hold risks for both parties.
Conclusion
Repurchase agreements are when sellers sell their securities to an investor. After a predetermined period, they repurchase their securities and pay a premium to the investors. In essence, repurchase agreements are loan transactions. Sellers can raise immediate finance with these agreements.
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