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A repurchase agreement (also known as a repo) is a sale of securities coupled with an agreement to repurchase the securities at a specified price on a later date. It is similar to a secured loan–the cash lender loans cash to a borrower and receives the borrower’s securities as collateral.
Repurchase agreements are generally considered safe investments because the security in question functions as collateral, which is why most agreements involve U.S. Treasury bonds. The Federal Reserve enters into repurchase agreements to regulate the money supply and bank reserves. Individuals normally use these agreements to finance the purchase of debt securities or other investments. Repurchase agreements are strictly short-term investments, and their maturity period is called the “rate,” the “term” or the tenor.
Example
Central banks often use repos to boost money supply, buying Treasury bills or other government paper from commercial banks so the banks can boost their reserves, and selling the paper back at a later date. When the central bank wants to tighten money supply, it sells the paper first, and buys it back later – this is called a reverse repo, an agreement to lend securities rather than funds.
Types of Repurchase agreements
Repurchase agreements are a type of financial transaction in which an individual uses financial securities as collateral for a loan. While the basic idea behind all repurchase agreements is the same, there are a few different types that an individual could utilize. Here are the different types of repurchase agreements.
1. Due Bill
With a due bill repurchase agreement, an internal account is used to keep the collateral for the lender. While a borrower would typically take the collateral to the lender, she instead places it in another bank account. This account is held under the name of the borrower for the duration of the transaction. This type of arrangement is not commonly used because it puts the lender in a position of risk since they are not fully in control of the collateral.
2. Tri-Party Repo
The tri-party repo is one of the most popular types of repurchase agreements in the market today. With this type of transaction, another party acts as the intermediary between the borrower and the lender. The borrower will give the third party the collateral, and the third party will then give the lender some type of substitution collateral. For example, if the borrower gave the third party a certain amount of stock, the lender could take an equal amount in bonds as collateral.
3. Whole Loan Repo
The whole loan repurchase agreement is another method that some lenders will use. With this type of transaction, they use a loan or some other debt obligation as the collateral instead of a financial security. For example, they might use a mortgage loan instead of stocks.
4. Equity Repo
This is a type of repurchase agreement that uses equities instead of bonds. The underlying security of the transaction will be stock in a company. In most cases, repurchase agreements use government bonds because they are very safe. However, this type of repurchase agreement adds a little bit of risk to the transaction because they are using company stock.
5. Sell/Buy Repo
With a sell/buy repo, a formal repurchase agreement is not actually put into place. Instead, they will sell a security and buy it on a forward repurchase at the same time. This is essentially the same thing as a traditional repurchase agreement except that it is completed in the financial markets.
6. Reverse Repo
A reverse repo is essentially the same type of transaction as a traditional repurchase agreement. The only difference is that the investor takes the security from the lender and immediately sells it on the open market. Then, when the time comes, the borrower will go out and purchase the same security and get it back to the lender.
7. Securities Lending
Securities lending is another type of repurchase agreement. This is typically done when an investor wants to go short on a particular type of security. He has to borrow the security in order to complete the financial transaction. Then he will give the security back to the lender.
