Repurchase agreements
A sale (and) repurchase agreement, also known as a (currency) repo, RP, or sale and repurchase agreement, is a transaction concluded on a deal date tD between two parties A and B:
(i) A will on the near date tN sell a specified security S at an agreed price PN to B
(ii) A will on the far date tF (after tN) re-purchase S from B at a price PF which is already pre-agreed on the deal date.
If we assume positive interest rates, the repurchase price PF can be expected to be greater than the original sale price PN.
The (time-adjusted) difference (PF-PN)/PN*(tF-tN)/365 is called the repo rate; it can be interpreted as the interest rate for the period between near date and far date.
The term repo has given rise to a lot of misunderstanding: there are two types of transactions with identical cash flows
(i) a sell-and-buy-back as well as,
(ii) a collateralized borrowing.
The sole difference is that in (i) the asset is sold (and later re-purchased), whereas in (ii) the asset is instead pledged as a collateral for a loan: in the sell-and-buy-back transaction the ownership and possession of S are transferred at tN from a A to B and in tF transferred back from B to A; conversely, in the repo only the possession is temporarily transferred to B whereas the ownership remains with A.
A reverse repo is a repo with the roles of A and B exchanged.
In a repo the party B acts as a lender of cash, whereas the seller A is acting as a borrower of cash, using the security as collateral; in a reverse repo (A) is the lender and (B) the borrower. A repo is economically similar to a secured loan, with the buyer (effectively the lender or investor) receiving securities for collateral to protect himself against default by the seller. The party who initially sells the securities is effectively the borrower. Many types of institutional investors engage in repo transactions, including mutual funds and hedge funds. Almost any security may be employed in a repo, though highly liquid securities are preferred as they are more easily disposed of in the event of a default and, more importantly, they can be easily obtained in the open market where the buyer has created a short position in the repo security by a reverse repo and market sale; by the same token, non liquid securities are discouraged. Treasury or Government bills, corporate and Treasury/Government bonds, and stocks may all be used as "collateral" in a repo transaction. Unlike a secured loan, however, legal title to the securities passes from the seller to the buyer. Coupons (interest payable to the owner of the securities) falling due while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller. This might seem counterintuitive, as the legal ownership of the collateral rests with the buyer during the repo agreement. The agreement might instead provide that the buyer receives the coupon, with the cash payable on repurchase being adjusted to compensate, though this is more typical of sell/buybacks.
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