REPOS REPURCHASE AGREEMENT

FATIMA JINNAH WOMEN UNIVERSITYASSIGNMENT

ESSENTIAL OF BANKING MANAGEMENT

REPOSREPURCHASE AGREEMENT

INTRODUCTION

Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset

On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds

They are usually very short-term, from overnight to 30 days or more than 30 days sometimes

DEFINITION

“A contract in which the seller of securities, such as Treasury Bills, agrees to buy them back at a specified

time and price.”

HISTORY

In US, repos have been used from as early as 1917 when wartime taxes made older forms of lending less attractive

First repos were used just by the Federal Reserve to lend to other banks

After fell away through the Great depression and WWII in 1920s, repos then expanded once again in the 1950s

Rapid growth in the 1970s and 1980s in part due to computer technology

EXPLANATION

The annualized rate of interest paid on the loan is known as the repo rate

Repos for longer than overnight are known as term repos.

repos that can be terminated by either side on a day’s notice are known as open repos

the seller of securities does a repo and the lender of funds does a reverse

EXPLANATIONThe overnight repo rate normally runs slightly

below the Fed funds rate for two reasons:  First a repo transaction is a secured loan, whereas the sale of Fed funds is an unsecured loan.Second, many who can invest in repos cannot sell Fed funds 

By rolling overnight repos, they can keep surplus funds invested without losing liquidity or incurring price risk

They also incur very little credit risk

Repos are classified as a money-market instrument

They are usually used to raise short-term capital

STRUCTURE AND TERMINOLOGY

A repo is economically similar to a secured loan

Highly liquid securities are preferred as they are more easily disposed of in the event of a default

Collaterals used in a repo transaction are:Treasury billsCorporate and Treasury/Government bondsStocks

Securities are resold and coupons are paid to the seller (borrower) at end of agreement

STRUCTURE AND TERMINOLOGY

TYPES OF REPURCHASE AGREEMENT

Term: Term refers to a repo with a specified end date. Open repo:

Open simply has no end date. In these agreements the buyer (the cash lender) or seller (a collateral provider) can terminate the repurchase agreement at any time.

IMPORTANCE OF REPOS

Repos are similar to Federal Funds except that Non-Banks can participate

Repos are utilized by central banks as an indirect instrument of monetary control for absorbing or injecting short term liquidity.

Fed buys or sells Treasury securities in the repo market to adjust the bank reserves.

FORMS OF REPOS

Specified delivery:It requires delivery of the bond at the start and at maturity of agreement.

Held in custody:A repo in which securities sold are held in custody by the seller for the buyer until maturity.

Buy-sell repo:In a buy-sell repo the ownership is passed on to the buyer and hence he retains any coupon interest due on the bonds.

• Tri-party: REPO

INVESTMENT DATE

INVESTOR (Money Market Fund)

1. Cash balance sent to custodian

TRI-PARTY

SECURITIES

AGENT

2. Dealer sends eligible securities

to custodian

3. Agent releases cash to dealer

REPO

DEALER

FORMS OF REPOS

FORMS OF REPOS

REPO MATURITY

DATE

INVESTOR (Money Market Fund)

6. Agent returns cash & interest

to money market fund

TRI-PARTY

SECURITIES

AGENT

TRI-PARTY

SECURITIES

AGENT

4. Dealer returns cash & interest at end

of term

5. Agent sends eligible

securities to the dealer

REPO

DEALER

MAJOR BORROWERS AND LENDERS

Borrowers:Government bond dealers of Treasuries Large banks

Lenders:State and local governmentsInsurance companiesLarge banksNon-financial corporations

REPO INTEREST INCOME

The difference between the underlying securities current price and repurchase price is the amount of interest paid by the borrower to

the lender.

HOW REPURCHASE AGREEMENTS WORK

Why the owner sells bond to someone and repurchase it at higher price?

The securities owner may need cash for a day or two, or a week or more.

Instead of taking out a short-term loan, he can sell the bond or stock to someone and promise to buy it back at a higher price.

Why would anyone want to own a security for such a short time?

Consider a money-market fund with excess cash that it needs to keep safe and provide a decent return on.

Its managers may be willing to transfer some of the cash for a short time in exchange for a higher-yielding security, such as a Treasury bond.

REPO MARKET

The over-the-counter repo market is now one of the largest and most active sectors in the US money market

Dealers in securities use repos to manage their liquidity, finance their inventories, and speculate in various ways. 

REPO MARKET PLAYERS

InvestorsBorrowersOther institutions

REPO ARE NOT FOR SMALL INVESTORS

The largest users of repos and reverses are the dealers in government securities. 

As of June 2008 there were 20 primary dealers recognized by the Fed.

Many dealers do repos and reverses in at least one million dollar chunks.

Big suppliers of repo money are money funds, large corporations, state and local governments, and foreign central banks.

WHO ELSE USES REPURCHASE AGREEMENTS

Central banks use repurchase

agreements to increase or reduce

the money supply. Companies, especially banks, may participate in repo markets to make productive use of cash on their balance sheets.

Repos are considered to be particularly safe, because the loan comes with collateral.

REVERSE REPOS

“A purchase of securities with an agreement to resell them at a higher price at a

specific future date.“This is essentially just a loan of the security at a specific

rate.

Reverse repo is exactly the opposite of repo – a party buys a security from another party with a commitment to sell it back to the latter at a specified time and price.

The difference between the price at which the securities are bought and sold is the lender’s profit or interest earned for lending the money.

The terms of contract are in terms of a ‘repo rate’, representing the money market borrowing/lending rate.

(Repo rate is the annual interest rate for the funds transferred by the lender to the borrower.)

REVERSE REPOS

USES OF REPOS

For the buyer, a repo is an opportunity to invest cash for a customized period of time.

For traders in trading firms, repos are used to finance long positions.

Securities dealers are primary users of overnight repos.

The Federal Reserve also uses repos for open market operations where they add or decrease reserves to the banking system by trading in US Treasury Securities.

Although repo transactions are backed by collateral, i.e. the lender can sell the securities to redeem the cash, a counter-party risk exists.

In addition to using repo as a funding vehicle, repo traders "make markets“. These traders have been traditionally known as "matched-book repo traders”.

The concept of a matched-book trade follows closely to that of a broker who takes both sides of an active trade, essentially having no market risk, only credit risk.

USES OF REPOS

RISK INVOLVE IN REPOS

Repurchase agreements, known as Repos, involve the sale and purchase of an asset at the same time. The assets used for Repos are usually U.S. Treasury securities.

Repos are essentially short-term loans that banks use to fund daily and weekly operations, and the risks involved include both credit risk and market risk.

BUYER’S CREDIT RISK

The buyer in a Repo transaction incurs credit risk when the deal is executed. If the seller, or counterparty, to the trade goes bankrupt before the Repo matures, then the buyer will be left holding the securities underlying the Repo trade.

BUYER’S MARKET RISK

Market risk in the context of Repos means interest rate risk. If the counterparty to the deal goes bankrupt before maturity, then the Repo buyer is exposed to the market risk caused by changes in interest rates.

SELLER’S CREDIT RISK

The seller in a Repo trade also has credit risk. If the counterparty goes bankrupt before the trade matures, then the securities that were loaned to the buyer might get stuck in bankruptcy proceedings and not returned to the seller.

SELLER’S MARKET RISK

In a mirror image of the market risk that the buyer assumes in a Repo deal, the seller can lose money if interest rates decline before maturity. If the buyer goes bankrupt, then the seller has an amount of cash that will be lower than the value of the securities that were loaned at the start of the trade.

CONCLUSION