What is a Repo?
A Repurchase Agreement, or “repo”, involves the sale of a Treasury security and subsequent repurchase shortly thereafter for a marginally higher price.
What is the Definition of Repurchase Agreement (Repo)?
A repo, or shorthand for “repurchase agreement”, is a secured, short-dated transaction with a guarantee of repurchase, similar to a collateralized loan.
Formerly known as “sale and repurchase agreements”, repos are contractual arrangements where a borrower – usually a government securities dealer – obtains short-term funding from the sale of securities to a lender.
The securities sold are often treasuries and agency mortgage securities, while the lenders are commonly money market funds, governments, pension funds and financial institutions.
For a pre-determined period, the borrower can purchase the securities back for the original price plus interest – e.g. the repo rate – usually completed overnight, as the primary intent is short-term liquidity.
The standard repo process is summarized below:
- A borrower sells securities to a counterparty – frequently to meet short-term liquidity needs – with the expectation of repurchasing on a nearby date.
- The borrower pledges securities that function like collateral per the terms of the lending agreement, much like a collateralized loan.
- The borrower repurchases the original security and accrued interest set by the repo rate, most often within one day.
- The lender profits from the transaction – i.e. a “reverse repo” from their viewpoint – based on the differential between the original sale price and repurchase price.
Repo Rate Formula
The formula to calculate the repo rate is as follows.
Repo Rate Formula
- Implied Repo Rate = (Repurchase Price – Original Selling Price / Original Selling Price) * (360 / n)
Where:
- Repurchase Price → Original Selling Price + Interest
- Original Selling Price → Sales Price of Security
- n → Number of Days to Maturity
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Hypothetically, suppose there is a repurchase agreement between a hedge fund and a money market fund.
The hedge fund has 10-year Treasury securities within its portfolio, and it needs to secure overnight financing to purchase more Treasury securities.
The money market fund has the capital that the hedge fund is currently seeking, and it is willing to accept the 10-year Treasury security as collateral.
On the date an agreement is reached, the hedge fund exchanges its 10-year Treasury securities for cash (and at a negotiated interest rate).
As is usual with repos, the hedge fund pays the money market fund the borrowing amount plus interest the next day – and the 10-year Treasury securities pledged as collateral is returned to the hedge fund to finalize the agreement.
Repo vs. Reverse Repo: What is the Difference?
Institutional bond investors rely heavily on the repo market, demonstrated by the approximately $2 to $4 trillion in repos that occur on a daily basis.
To the market participants – the seller of the bond and the purchaser of the bond – there are monetary benefits that make these short-term transactions attractive.
For the seller, the repo market presents a short-term, secured financing option that can be obtained relatively easily, which can be especially useful for banks looking to fulfill their overnight reserve requirements.
Repos and reverse repos represent the opposing sides of the lending transaction – and the distinction depends on the counterparty’s viewpoint.
In contrast, a reverse repurchase agreement (or “reverse repo”) is when the purchaser of the security agrees to re-sell the security back to the seller for a pre-determined price at a later date.
From the perspective of the buyer, the agreement is a reverse repurchase agreement, considering they are on the other side of the transaction.
The transaction benefits the buyers from the interest received from purchasing the security, and since it is a low-risk, safe transaction given its collateralized nature.
Buyers can also use reverse repurchase agreements to satisfy obligations made to other firms in the form of cash or Treasury securities.
Repo and reverse repo agreements are both tools associated with open market operations to support the effective implementation of monetary policies and ensure smooth sailing in the markets.
What is the Role of the Fed in the Repo Market?
The Fed uses repos as a method of conducting temporary open market operations (TOMOs).
After the Federal Open Market Committee (FOMC) agrees on the target fed funds range, it influences the current fed funds rate by conducting open market operations, with repos representing one such method.
The mechanics of a repurchase agreement involving the Fed are similar to an ordinary repo.
Through its Standing Repo Facility (SRF), the Fed sells securities on the open market and repurchases them shortly thereafter at face value plus interest.
The Fed’s SRF acts as a ceiling to help dampen upward interest rate pressures that occasionally arise in overnight funding markets.
How to Determine the Repo Rate?
The repo rate and fed funds rate will move in line with each other, given that both are used for short-term financing. Therefore, the biggest influence on the repo rate is the Federal Reserve and its influence over the fed funds rate.
Commercial banks also play a huge role in determining the supply and demand that drives changes in the repo rate so commercial banks could be seen as a third key player.
The commercial bank can act on both sides of a repurchase agreement, depending on their needs.
- If the commercial bank needs to satisfy reserve requirements, it will sell bonds.
- If it takes on a large deposit or otherwise has the cash to invest, it will purchase bonds.
If there are discrepancies in the two rates, commercial banks will act on them in order to profit.
If the fed funds rate is higher than the repo rate, then banks would lend in the fed funds market and borrow in the repo market, and vice versa if the repo rate is higher than the fed funds rate.
Eventually, the supply and demand for borrowing and lending in either of these markets would “balance out” and lead to a prevailing market rate.
