Repurchase Agreements Characteristics
Repurchase agreements, commonly referred to as “repos,” are a type of financial instrument that allows one party to sell securities to another party with an agreement to repurchase them later at an agreed-upon price. Repos are widely used in the financial industry as a tool for short-term borrowing and lending, and are an integral part of the money market. In this article, we`ll cover the characteristics of repurchase agreements and how they work.
Characteristics of Repurchase Agreements:
1. Collateralized: Repurchase agreements are collateralized transactions, meaning that the seller of the securities (also known as the borrower) must provide collateral in the form of the securities being sold. This collateral provides security to the buyer of the securities (also known as the lender) in case the borrower is unable to repurchase the securities.
2. Short-Term: Repurchase agreements are typically short-term transactions, with most repos having terms of less than one week. This short-term nature makes them an attractive option for investors who need to borrow funds for a short period.
3. Interest rates: Repurchase agreements are usually offered at an interest rate slightly below the prevailing market rate for short-term borrowing. The difference between the market rate and the repo rate is referred to as the “repo rate spread.”
4. Low Risk: Repurchase agreements are considered low risk because they are collateralized transactions. This means that the buyer of the securities has a claim on the collateral in case the borrower defaults, making it a relatively safe investment.
How Repurchase Agreements Work:
1. Borrower sells securities to a lender: The borrower sells securities to the lender and agrees to repurchase them at a later date. The securities are used as collateral for the transaction.
2. Loan is made: The lender provides cash to the borrower, with the cash loan amount being less than the market value of the securities sold.
3. Interest accrues: The borrower pays interest to the lender on the cash loan amount, and the interest rate is determined by the repo rate spread.
4. Repurchase date: On the repurchase date, the borrower repurchases the securities at the agreed-upon price, which includes the original sale price plus interest.
5. Transaction is complete: The repurchase agreement is complete once the borrower repurchases the securities. If the borrower fails to repurchase the securities, the lender can sell the securities to recover their funds.
Repurchase agreements are a popular tool in the financial industry for short-term borrowing and lending. They are collateralized transactions that are considered low risk due to the collateral provided. The interest rate on repurchase agreements is typically slightly below the prevailing market rate, making them an attractive option for investors who need to borrow funds for a short period.