Repurchase Agreements (repos)

A repurchase (repo) agreement⇒ is an arrangement by which one party sells a security to a counterparty with a commitment to buy it back at a later date at a specified (higher) price. The repurchase price is greater than the selling price and accounts for the interest charged by the buyer, who is, in effect, lending funds to the seller with the security as collateral. The interest rate implied by the two prices is called the repo rate, which is the annualized percentage difference between the two prices. A repurchase agreement for one day is called an overnight repo and an agreement covering a longer period is called a term repo. The interest cost of a repo is customarily less than the rate on bank loans or other short-term borrowing.

As an example, consider a firm that enters into a repo agreement to sell a 4%, 12-year bond with a par value of $1 million and a market value of $970,000 for $940,000 and to repurchase it 90 days later (the repo date) for $947,050.

The implicit interest rate for the 90-day loan period is 947,050 / 940,000 – 1 = 0.75% and the repo rate would be expressed as the equivalent annual rate.

The percentage difference between the market value and the amount loaned is called the repo margin or the haircut. In our example, it is 940,000 / 970,000 – 1 = –3.1%. This margin protects the lender in the event that the value of the security decreases over the term of the repo agreement.

The repo rate is:

• Higher, the longer the repo term.
• Lower, the higher the credit quality of the collateral security.
• Lower when the collateral security is delivered to the lender.
• Higher when the interest rates for alternative sources of funds are higher.

The repo margin is influenced by similar factors. The repo margin is:

• Higher, the longer the repo term.
• Lower, the higher the credit quality of the collateral security.
• Lower, the higher the credit quality of the borrower.
• Lower when the collateral security is in high demand or low supply.

The reason the supply and demand conditions for the collateral security affects pricing is that some lenders want to own a specific bond or type of bond as collateral. For a bond that is high demand, lenders must compete for bonds by offering lower repo lending rates.

Viewed from the standpoint of a bond dealer, a reverse repo agreement refers to taking the opposite side of a repurchase transaction, lending funds by buying the collateral security rather than selling the collateral security to borrow funds