Repurchase Transaction

Repurchase Transaction Repo Discounting Negotiable Instruments Corporate Financing Bank Transactions Financial Markets Short-Term Funding
A repurchase transaction, also known as a 'repo,' is a form of discounting where a corporation raises immediate funds by selling negotiable paper to a bank with the agreement to repurchase the paper upon its maturity.
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Definition of Repurchase Transaction

A Repurchase Transaction (repo) is a short-term funding agreement typically seen in financial markets where an entity, usually a corporation, sells negotiable instruments like government bonds or commercial paper to a bank or other financial institution with a commitment to repurchase these instruments at a specified future date for a higher price. The difference in the sale and repurchase price represents the cost of borrowing to the seller, which is equivalent to an interest payment.

Repos are widely used for raising short-term capital as they offer liquidity and flexibility. They provide the buyer (the lender) with a secure, fixed-income investment while offering the seller (the borrower) an efficient means of accessing funds by leveraging the underlying securities.

Examples of Repurchase Transactions

  1. Short-Term Corporate Financing: A corporation needing short-term cash flow sells its stock of company bonds to a bank with an agreement to repurchase them in 30 days at a higher price.

  2. Government Repos: Governments can use repos to manage liquidity by selling treasury bills to financial institutions with agreements to repurchase them within a week.

Frequently Asked Questions

Q1: How does a repurchase transaction differ from a collateralized loan?

A1: In a repurchase transaction, the ownership of the securities temporarily transfers to the buyer, whereas in a collateralized loan, the borrower retains ownership of the collateral but the lender has a claim over it.

Q2: Why are repurchase transactions considered secure investments for lenders?

A2: They are considered secure because the lender has the ownership of high-quality negotiable instruments, like government bonds, which can be liquidated if the borrower defaults.

Q3: What is the typical duration of a repurchase transaction?

A3: The duration can vary from overnight to several months, typically ranging from 1 to 90 days. Longer durations are less common due to market preferences for short-term liquidity.

Q4: What are the risks associated with repurchase transactions?

A4: Risks include counterparty risk if the seller defaults, and market risk if the value of the underlying securities decreases.

  • Negotiable Instrument: A written document guaranteeing the payment of a specific amount of money either on demand or at a set time, such as checks, promissory notes, and bills of exchange.

  • Discounting: The act of obtaining funds by selling a financial instrument at a value less than its face value, usually before its maturity date.

  • Secured Borrowing: A loan where the borrower pledges an asset as collateral, offering the lender protection against default.

Online References

  1. Investopedia: Repurchase Agreement
  2. Federal Reserve Bank of New York: Repurchase Agreement (Repo)
  3. Corporate Finance Institute: What is a Repo?

Suggested Books for Further Studies

  1. “Repo Handbook” by Moorad Choudhry
  2. “The Art of Central Banking” by R.G. Hawtrey
  3. “Fixed Income Markets and Their Derivatives” by Suresh Sundaresan

Accounting Basics: “Repurchase Transaction” Fundamentals Quiz

### What is a repurchase transaction often referred to as in financial markets? - [ ] Collateralized loan - [ ] Mortgage-backed security - [x] Repo - [ ] Discount bond > **Explanation:** A repurchase transaction is commonly referred to as a 'repo' in financial markets. ### What type of financial instrument is typically used in a repurchase transaction? - [x] Negotiable paper - [ ] Real estate - [ ] Inventory - [ ] Intellectual property > **Explanation:** Repos typically use negotiable instruments, like government bonds or corporate debt securities, as the underlying financial instruments. ### Who typically conducts repurchase transactions? - [ ] Individual retail investors - [x] Corporations and financial institutions - [ ] Homeowners - [ ] Commercial real estate agents > **Explanation:** Repurchase transactions are mainly conducted by corporations and financial institutions looking for short-term liquidity solutions. ### What is the main benefit of a repurchase transaction to the seller? - [x] Access to short-term funding secured by negotiable instruments - [ ] Long-term capital investment - [ ] Increase in asset valuation - [ ] Permanent sale of the securities > **Explanation:** The main benefit is access to short-term funding while still retaining the title to repurchase the sold securities. ### How is the cost of borrowing represented in a repurchase transaction? - [ ] As a fixed fee - [x] As the difference between the sale and repurchase price - [ ] As the initial deposit amount - [ ] As the total value of the securities > **Explanation:** The cost of borrowing in a repo transaction is represented by the difference between the initial sale price and the repurchase price. ### Why are repos considered safer by lenders? - [ ] Because they have a guaranteed fixed return - [ ] Because the transactions are backed by government guarantees - [x] Because lenders take ownership of high-quality securities - [ ] Because interest rates are fixed > **Explanation:** Repos are considered safer by lenders because they take temporary ownership of high-quality, liquid securities which can be sold quickly if necessary. ### What happens at the maturity of a repurchase agreement? - [ ] The lender sells the securities in the open market - [ ] The agreement converts into a permanent sale - [ ] The securities are returned to the borrower without any payment - [x] The borrower repurchases the securities at a higher price > **Explanation:** At maturity, the borrower repurchases the securities at the previously agreed higher price. ### What is a potential risk for the lender in a repurchase transaction? - [x] Counterparty risk - [ ] High-interest rates - [ ] Low return on investment - [ ] Regulatory changes > **Explanation:** The primary risk for the lender is counterparty risk, where the borrower might default on the agreement. ### How does the duration of repurchase transactions typically compare with other forms of borrowing? - [ ] Repos are usually longer term - [x] Repos are generally short term - [ ] Repos have the same term as bonds - [ ] Repos have a variable-length term > **Explanation:** Repos are typically short-term agreements, often ranging from overnight to a few months. ### How does a repurchase agreement affect the borrower's balance sheet? - [ ] It permanently decreases their asset holdings - [x] It temporarily increases their cash holdings - [ ] It does not impact their financial statements - [ ] It converts equity into liabilities > **Explanation:** A repo temporarily increases the borrower's cash holdings as they obtain short-term liquidity by selling securities with an agreement to repurchase them later.

Thank you for engaging in this explorative journey into repurchase transactions and testing your knowledge with our quiz questions. Keep enhancing your financial comprehension!

Tuesday, August 6, 2024
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Repurchase Agreement (Repo)

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