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Repurchase agreements (repos), their types and risks

A repurchase agreement (or repo) is a sale of a security with a simultaneous agreement to buy back the security at an agreed price and date. It is effectively a collateralized loan.

Repo markets are an important source of funding both for banks and other participants such as dealers. An active repo market is essential for a liquid bond market. Central banks also participate in repo markets to carry out open market operations.

A repo is created when the party who owns the asset sells it to another party for cash and at the same time promises to buy it back on the repurchase date at a specified repurchase price.

Types of repos

A repo with the maturity of 1 day is called overnight repo, and repo with longer maturity is called term repo. A repo whose term matches the tenor of the collateralized asset is called a repo to maturity.

Repo rate and its determinants

Repo rate, the rate at which finding is obtained in a repo depends on:

  • The risk associated with collateral: repo rate is low when the security is highly rated.
  • The term of the repo: repo rate increases with an increase in maturity.
  • The delivery requirement: repo rate is lower when delivery is required.
  • The supply and demand conditions: repo rate is low when the collateral is in high demand.
  • The interest rates of alternative financing: high alternative financing rate means a high repo rate.

The interest earned on a repo is paid on the repurchase date and any income earned during the repo term accrued to the borrower.

Reverse repo

A repo when looked at from the perspective of the lender is called a reverse repo. The standard perspective is to look at a repurchase agreement from the point of view of a dealer.

Credit risk in repos

Credit risk exists in a repurchase agreement even if the collateral is of very high quality. It is because the value of the collateral may fall during the term of the repo in which case the investor (lender) faces a risk of default by the borrower. Also, when the price of collateral increases, the investor (lender) is liable to the borrower for any excess of the collateral value over the loaned amount and the borrower faces a risk of default by the lender.

Repo margin and its determinants

A repo is structured so as to protect the lender, i.e. the loan amount is less than the market value of collateral by an amount called repo margin (also referred to as haircut).

Repo margins provide a cushion against deterioration in the market value of the collateral and they depend on:

  • Length of repo agreement: higher margin needed for longer agreements.
  • Quality of collateral: lower margin needed when collateral quality is high.
  • The credit quality of counterparty: lower margin when credit quality is high.
  • Supply and demand conditions: lower margin when collateral is in short supply.

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