Demystifying Repurchase Agreements (Repos): A Primer
In the intricate realm of financial transactions, the repurchase agreement, commonly referred to as the "repo," stands as a vital tool for short-term borrowing and lending. It serves both buyers and sellers in enabling smooth financial operations and efficient liquidity management.
1. Basics of a Repo Transaction
A repurchase agreement consists of two primary stages:
Initial Transaction: Here, the seller offers collateral, typically in the form of bonds or other securities, to the buyer. The buyer then provides an amount equivalent to the market valuation of the collateral, which incorporates any due interest.
Maturity: Once the agreed-upon tenure is reached, the buyer gives back the collateral. Concurrently, the seller returns the initial amount received plus an additional interest. This interest, referred to as the "repo rate," is often determined based on money market standards, such as the actual/360 method.
The terms, encompassing the type of collateral, transaction's duration (usually short-term, ranging from a day to a few months), the cash amount, and the repo rate, are established when dealers initiate a repo trade.
2. Risk Dynamics
Throughout the repo's life, both market and credit risks linked to the collateral persist with the seller. This is due to the seller's commitment to repurchasing the asset at an agreed-upon sum at maturity. Moreover, should there be any coupon payment linked to the collateral during the repo's duration, the buyer is mandated to relay this to the seller.
3. The Motive Behind Repo Trades
Repos are popular for two main reasons:
Shorting the Market: Dealers might predict a price drop and opt to sell securities they don't possess, aiming to repurchase them later at reduced rates. This strategy, known as "going short," necessitates borrowing the security, thus prompting the dealer to engage in a reverse repo.
Liquidity Management: Those possessing bonds can employ them as collateral to borrow funds. Given that the repo rate can sometimes be below standard money market rates, repos can be a strategic instrument for managing liquidity.
4. General vs. Special Collateral Rates
The repo rate usually aligns closely with money market rates, known as the general collateral rate. However, in situations where a specific security is in high demand, its repo rate might dip considerably below prevailing rates, earning it the label of a "special rate."
5. Haircuts in the Repo Market
To manage the risk associated with volatile bonds, the repo market introduces "haircuts" or margins. For instance, a 2% haircut on a repo deal involving collateral valued at $10 million would mean the seller gets only $9.8 million from the buyer, with the repo interest calculated on this reduced amount.
6. Buy/Sell Back Transactions
These transactions mirror repos regarding collateral and cash flow dynamics but differ structurally. Here, the focus is on a spot purchase and a subsequent forward sale of the collateral. This structure pivots on spot and forward prices instead of an interest rate.
In conclusion, repurchase agreements form the backbone of short-term financing in financial markets. By providing a framework for borrowing and lending using securities as collateral, repos facilitate liquidity management and efficient capital allocation for both dealers and portfolio managers.
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Repo used to cover short sale:
