Repurchase Agreement

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Certain financial instruments that are customarily used in capital markets and money markets are known as repurchase agreements or commonly terms as repos. However, in reality, these agreements are sale & repurchase agreement. A typical example is when a person sells certain amount of securities for cash now but agrees to repurchase them for a higher price at a later date. The seller, buyer, and the excess cash are termed as repo seller, repo buyer and repo rate. The repo rate is an implicit interest rate. Corporate shares/stocks, corporate bonds, treasury/government bonds, and treasury/government bills are the instruments that are widely used in repo transactions.

Repos are usually short-term. However, some repos can have maturity periods of even two years. In pure economic terms, repos are like secured loans. However, in the case of a secured loan, the legal title rests with the creditor and not with the debtor. On the other hand, in a repo agreement, ‘coupons’, which are monthly installments, are paid to the repo seller, though technically the buyer who provides the cash owns the securities offered as collateral.

Individual investors look at repos as safe short-term investments, since they obtain secured collateral at competitive rates with high market liquidity. Traders get cheap finance through repos to finance ‘long’ positions and to cover ‘short’ positions. When a repo seller fails to repurchase the securities offered as collateral at the time of repo maturity, the repo buyer is free to liquidate the securities for recovery of the cash that was lent. Normally, repos are overcollateralized to cover the risk due to the fact that the securities might have depreciated in value because of market vagaries. Terms of repo, perceived liquidity of the securities, and the financial strengths of the parties involved, determine the credit risk.

Repo maturities are of three types. One-day maturity transactions are overnight repos. Repos with a specific date of maturity are term repos. Open repos do not have any maturity date. Repo transactions are also of three kinds. Specified deliveries require delivery both at the beginning and at the end of the transactions. When a wide range of instruments are placed in a basket involving a triparty agent, the transaction is known as triparty. The third type, held-in-custody repos are quite rare due to high market risks.