In the financial market, Repurchase Agreement or Repo is an investment instrument that is commonly used by many parties. In this case, Repo allows parties who need short-term funds to obtain sources of funding by selling their assets to other parties with an agreement to buy them back at a certain date in the future at a higher price. This is a solution for parties who need liquidity in a short time, such as banks, financial institutions and institutional investors.
In this article, we will discuss the characteristics and types of Repos, as well as provide simple examples of how Repos work in financial markets.
What is a Repurchase Agreement (Repo)?
Repurchase Agreement (Repo) is a temporary sale and purchase transaction in which the selling party (seller) agrees to repurchase an asset from the buyer at a certain date in the future at a price previously agreed upon. In a Repo, the assets sold are usually in the form of securities, such as bonds or certificates of deposit, as collateral for payment of a loan provided by the buyer.
In a Repo transaction, the buyer provides a sum of money to the seller as payment for the securities purchased. After a certain period of time (usually a few days or a few weeks), the seller agrees to buy back the securities from the buyer at a pre-agreed price. The difference between the selling price and the buying price is referred to as interest or yield.
Repo transactions are usually carried out by banks, financial institutions and institutional investors to obtain short-term funds or to profit from the difference in interest rates between the purchase and sale of securities. Repo transactions are also used by central banks to control financial market liquidity and to influence market interest rates.
Characteristics of Repurchase Agreements
Following are some of the characteristics of a Repurchase Agreement (Repo):
Type of Asset: Repos involve the temporary sale and purchase of a particular asset, such as bonds or certificates of deposit.
1. Timeframe: Repos are generally done over a short timeframe, from a few days to a few weeks.
Price: The price agreed to repurchase the asset in the future is usually higher than the current sale price for the asset, so the buyer will receive a return on their investment.
2. Credit Risk: In a Repo, there is credit risk associated with the seller. The buyer must ensure that the seller can repurchase the asset on the agreed date.
3. Ownership of Assets: Even if the asset is temporarily sold to a buyer, ownership of the asset remains with the seller until the buyer repurchases the asset.
4. Flexible Nature: Repo is a relatively flexible financial instrument as it allows a bank or financial institution to obtain short-term funds or to optimize their investment portfolio.
5. Liquidity: Repos are highly liquid because the assets sold are usually those that are widely traded and easily identifiable. This allows parties to easily buy or sell assets back into the market.
Example Repurchase Agreement
Here is a simple example of a Repurchase Agreement (Repo):
Bank A has a $100 million portfolio of bonds with a one-year maturity and an interest rate of 3% per annum. Bank A wants to obtain short-term funds and submits a Repo request to Bank B.
Bank B agrees to buy $100 million worth of bonds from Bank A for $99 million. Under the Repo deal, Bank A agreed to buy back the bonds for $100 million within one month.
Over the course of one month, Bank B has temporary ownership of the bonds and receives a yield of 1% (the difference between the selling price and the buying price) or $1 million.
After one month, Bank A bought back $100 million worth of bonds from Bank B for $100 million. Under this Repo deal, Bank B earns a yield of $1 million within one month.
In this example, Bank A raises $99 million in short-term funding by selling its bonds to Bank B and applying for a Repo. On the other hand, Bank B earns a yield of 1% for one month by buying the bonds and selling them back to Bank A.
Types of Repurchase Agreement
There are several types of Repurchase Agreement (Repo) that are commonly used in financial markets. Here are some of them:
1. Overnight Repo: This type of Repo has the shortest timeframe, i.e. one day or one night. Overnight Repos are usually carried out by central banks to control financial market liquidity.
2. Term Repo: Term Repo is a type of Repo that has a longer term than Overnight Repo. The timeframe can be from a few days to a few weeks. Term Repos are usually carried out by financial institutions and institutional investors who need short-term funds.
3. Sell/Buyback: Sell/Buyback is another form of Repo where the seller agrees to sell an asset to a buyer at an agreed price and agrees to buy back the asset at a certain date in the future at a higher price. In Sell/Buyback, the selling and buying prices of assets are different.
4. Reverse Repo: Reverse Repo is a type of Repo in which the buyer lends money to the seller and receives assets as collateral. In a Reverse Repo, the seller promises to buy back the asset at a certain date in the future at a higher price. Reverse Repo is usually carried out by central banks to withdraw money from financial markets and stabilize interest rates.
5. Tri-Party Repo: Tri-Party Repo involves a third party, namely the custodian bank, which acts as the party that arranges transactions between sellers and buyers. Tri-Party Repo is used to facilitate transaction settlement and minimize credit risk between the two parties.
So, in conclusion, Repurchase Agreement or Repo is a popular investment instrument. Repos allow parties who need short-term funds to obtain sources of funding by selling their assets to other parties with an agreement to buy them back at a certain date in the future at a higher price. The types of Repo that are commonly used include Overnight Repo, Term Repo, Sell/Buyback, Reverse Repo, and Tri-Party Repo. Each type of Repo has different characteristics and objectives depending on the needs of each party. In making Repo investments, it is important for investors to understand the risks and rewards associated with the type of Repo they are using.