Repurchase agreement

Repurchase agreement

A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party that originally buys the securities effectively acts as a lender. The original seller is effectively acting as a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest.

A repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between the forward price and the spot price is effectively the interest on the loan while one of the settlement dates of the forward contract is the maturity date of the loan.

 

[Dhruv Bindhani]

This article provides a clear and concise definition of a repurchase agreement (repo), effectively explaining its core mechanics and financial implications.

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Understanding Repurchase Agreements (Repos)​

The article defines a repurchase agreement, commonly known as a repo or RP, as the "sale of securities together with an agreement for the seller to buy back the securities at a later date." This fundamental concept immediately clarifies the dual nature of the transaction.

It further explains that the "repurchase price should be greater than the original sale price," with this difference serving as the effective interest, often referred to as the repo rate. This highlights the cost associated with this form of borrowing.

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Repo as a Secured Lending Mechanism​

The article then elucidates the roles of the parties involved:

• The party that originally buys the securities is effectively acting as a lender.
• The original seller is effectively acting as a borrower, using their securities as collateral for a "secured cash loan at a fixed rate of interest."

This clarifies the underlying financial function of a repo as a short-term, collateralized borrowing and lending arrangement.

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Repo as a Combination of Transactions​

To further simplify the concept, the article presents a repo as being "equivalent to a cash transaction combined with a forward contract."

• The cash transaction involves the "transfer of money to the borrower in exchange for legal transfer of the security to the lender." This represents the immediate cash flow and collateral transfer.
• The forward contract "ensures repayment of the loan to the lender and return of the collateral of the borrower." This element guarantees the buy-back and loan repayment.

The article concludes by stating that "The difference between the forward price and the spot price is effectively the interest on the loan," and "one of the settlement dates of the forward contract is the maturity date of the loan." This succinctly ties the mechanics of the forward contract to the interest and maturity terms of the repo.

Overall, the article offers a precise and easily understandable explanation of repurchase agreements, making complex financial concepts accessible.