Definition
A repurchase agreement, also known as a repo, is a form of short-term borrowing for dealers in government securities. In a repo, the dealer sells the government securities to investors, typically on an overnight basis, and then buys them back the next day at a slightly higher price. This transaction resembles a collateralized loan, where the securities provide the collateral.
Key Characteristics
- Short-Term: Repos are usually short-term agreements with durations from overnight to a few days.
- Collateral: The government securities act as collateral, providing security to the lender.
- Interest: The difference between the repurchase price and the original sale price represents the interest on the loan.
Examples
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Overnight Repo:
- A dealer sells $1 million worth of government securities to an investor for cash. The following day, the dealer repurchases them at $1.002 million, reflecting an overnight interest rate.
-
Term Repo:
- A dealer agrees to sell $500,000 worth of securities to an investor with an agreement to repurchase them in a week at $502,000, demonstrating term borrowing with a slightly longer maturity.
Frequently Asked Questions
What is a repurchase agreement used for?
Repurchase agreements are used by financial institutions to raise short-term capital. They allow dealers in government securities to manage liquidity by temporarily selling assets and repurchasing them shortly afterward.
How is a repurchase agreement different from a loan?
In a repurchase agreement, the seller of the securities agrees to buy them back at a later date, making it a form of secured borrowing. The securities serve as collateral for the borrowing entity. In contrast, a standard loan does not necessarily involve the exchange of securities.
Why do investors engage in repurchase agreements?
Investors engage in repos to earn a return on excess cash in a low-risk manner. Since the transactions are collateralized with government securities, the credit risk is typically very low.
Are there risks associated with repurchase agreements?
Yes, risks include counterparty risk (the risk that the other party defaults), interest rate risk, and liquidity risk. Though generally low-risk, these transactions are not entirely risk-free.
What is the reverse repurchase agreement?
A reverse repurchase agreement (reverse repo) is the opposite side of a repurchase agreement. In a reverse repo, the investor lends money by purchasing securities with the agreement to sell them back in the future.
- Reverse Repurchase Agreement (Reverse Repo): The purchase of securities with the agreement to sell them back at a specified date and price, essentially the lender’s side of a repo.
- Collateral: An asset that a borrower offers to a lender to secure a loan.
- Liquidity: The ease with which an asset can be converted into cash without affecting its market price.
- Government Securities: Financial instruments issued by the government to support government spending; these include treasury bills, bonds, and notes.
Online Resources
Suggested Books for Further Studies
- “Repurchase Agreements in Financial Markets” by Frank J. Fabozzi
- “Fixed Income Securities: Tools for Today’s Markets” by Bruce Tuckman
- “The Repo Handbook” by Moorad Choudhry
- “Bond Markets, Analysis, and Strategies” by Frank J. Fabozzi
Accounting Basics: “Repurchase Agreement (Repo)” Fundamentals Quiz
### What is a primary use of repurchase agreements?
- [ ] For long-term investment
- [x] To raise short-term capital
- [ ] For buying consumer goods
- [ ] For personal loans
> **Explanation:** Repurchase agreements are typically used to raise short-term capital by financial institutions by temporarily selling government securities.
### How is the interest on a repurchase agreement determined?
- [ ] By the Federal Reserve directly
- [x] By the difference between the sale and repurchase price
- [ ] Through a fixed annual rate
- [ ] By mutual agreement without any collateral consideration
> **Explanation:** The interest on a repurchase agreement is determined by the difference between the repurchase price and the original sale price of the securities.
### Which financial instrument serves as collateral in a repurchase agreement?
- [x] Government Securities
- [ ] Corporate Bonds
- [ ] Stocks
- [ ] Real Estate
> **Explanation:** Government securities often serve as collateral in repurchase agreements due to their low risk and liquidity.
### How long do repurchase agreements typically last?
- [ ] Several months
- [ ] Several years
- [x] Overnight to a few days
- [ ] Over five years
> **Explanation:** Repos are usually very short-term transactions, often lasting from overnight to a few days.
### What is a reverse repurchase agreement?
- [ ] The same as a repurchase agreement
- [ ] An unsecured loan
- [x] The opposite transaction of a repurchase agreement
- [ ] A type of fixed deposit
> **Explanation:** A reverse repurchase agreement is when an investor lends money by purchasing securities and agrees to sell them back in the future, essentially the opposite side of a repo.
### What type of risk is primarily associated with repurchase agreements?
- [ ] No Risk
- [ ] High Risk
- [x] Counterparty Risk
- [ ] Politically Motivated Risk
> **Explanation:** The primary risk associated with repurchase agreements is counterparty risk, which is the risk that the other party will default on its obligation.
### Can investors use repos to earn a low-risk return?
- [x] Yes, repos provide a low-risk return as they are secured by government securities.
- [ ] No, they are too risky for investors.
- [ ] Only if they are long-term repos.
- [ ] Only if no collateral is involved.
> **Explanation:** Investors can earn a low-risk return using repos as they are secured by government securities, making the investment relatively safe.
### Do repurchase agreements involve the exchange of securities?
- [x] Yes, securities are sold and later repurchased.
- [ ] No, only money is exchanged.
- [ ] Sometimes, depending on the agreement.
- [ ] Only in informal settings.
> **Explanation:** Repurchase agreements involve the sale of securities with the agreement to repurchase them later, effectively collateralizing the short-term loan.
### What is one of the key benefits of repurchase agreements for dealers?
- [ ] Long-term capital
- [ ] Personal use financing
- [x] Managing short-term liquidity
- [ ] Avoiding taxes
> **Explanation:** One of the primary benefits of repurchase agreements for dealers is managing short-term liquidity by temporarily selling securities.
### In which market are repurchase agreements most commonly used?
- [x] Government Securities Market
- [ ] Real Estate Market
- [ ] Consumer Goods Market
- [ ] Cryptocurrency Market
> **Explanation:** Repurchase agreements are most commonly used in the government securities market where they serve as short-term borrowing tools for dealers.
