Sunday, January 10, 2010

What is a repo/reverse repo?

A repo is a repurchase transaction and it is a security that is part of the money market.

So what is a repurchase transaction? A repurchase transaction is similar to a transaction that takes place in a pawn shop. The owner of a property goes to a pawn shop and exchange it for cash but he promises to come back later to buy the property at a higher price.

Now the same goes for a repo.

1. An institution that needs cash over a short period of time goes to lender with government securities such as government bonds, treasury bills or any other financial instruments that have a high rating as collateral.

2. The lender will lend money to the borrower in exchange for the collateral. The borrower also agrees to buy back the security at a higher price at a particular time.  The difference between the two price is the profit of the lender. The time of repurchase can be from one day to a few months.If the repo transaction is greater than a month it is called a term repo. Less than a month it will be a simple repo.

3. At the agreed time the borrower buy back the collateral at the agreed higher price.

4. In case of default of the borrower the lender keep the collateral.   

You can also have what is called a reverse repo. This is the opposite of a repo. In a reverse repo the the institution will buy a security and later agree to sell the security to the seller at a higher price.

Technically the two terms are used in different circumstances but put simply if the transactions is viewed from the borrower’s perspective where the borrower will repurchase the security later it is a repo but from the lender’s perspective the lender is forced to sell the security to the borrower then it is a reverse repo.

A typical case is when banks obtain funds from the central bank. the bank is considered to be doing a repo while the central bank is considered to be doing a reverse repo.

However it is mostly large institutions that deal in repos.

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