A Repurchase agreement (repo) is a secured loan for a short period of time. A repo is a kind of short-term borrowing mostly in case of government securities. The Repo market plays the main role in facilitating the flow of cash and securities around the financial system, with benefits to both financial and non-financial firms. A well-functioning repo market also supports liquidity in other markets and therefore contributes to the efficient allocation of capital in the real economy.
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However, excess use of repos also provides the build-up of leverage and be reliant on short-term funding. Repos are mostly used to raise short-term capital. The main difference between the securities starting price and their repurchase price is the interest that is paid on the loan known as repo rate.
A reverse repurchase agreement (reverse repo) is similar to a repo transaction. In a reverse repo, we have bought securities and agrees to sell them back to B for a positive return at a later date as soon as the next day to earn the profit. Most of the repos are overnight that’s why they exist for a longer duration.
What Repos arrangement offers to lenders and borrowers?
The major benefit of repos to borrowers is that the repo rate is less than borrowing from a bank. The main benefit to lenders over other money market instruments such as commercial papers is that the maturity of the repo can be easily tailored to the lender’s needs.
Most borrowers are government bond dealers of Treasuries and federal agency securities, large banks, NBFCs, and also dealers in bankers’ acceptance, CD, and Euros. Government securities are the major series of collateral for repos, along with federal agency securities, mortgage-backed securities, and other money market instruments.
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The risk involved in Repo Markets
Repurchase agreements are usually seen as credit-risk mitigated instruments. The biggest risk in a repo is that the seller might fail to hold up its end of the agreement by not repurchasing the securities which it sold at the maturity date. The buyer of the security may then sell the security in order to attempt to recover the cash that it paid out initially to maintain the level of liquidity in the market. On the other hand, there is a risk for the borrower in this transaction as well if the value of the security rises above the agreed-upon terms, the creditor may not sell the security back.
There are various methods for building the repurchase agreement space to help mitigate this risk. In most cases, if the collateral falls in value, a margin call can take effect to ask the borrower to amend the securities offered. It appears likely that the value of the security may rise and the creditor may not sell it back to the borrower, under-collateralization can be utilized to mitigate risk in the market.
Generally, credit risk for repurchase agreements is completely dependent on many factors including the terms of the transaction, liquidity of the security, specifics of the counterparties involved, and much more.
Author: Yash Tanwar
About the Author: Commerce graduate from the University of Delhi who is currently pursuing FRM Part-1 2020. He wants to obtain a stronger track record of result making and gain something new skill sets that are applicable to Finance specifically in risk domain.