Repurchase Agreements

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Repurchase agreements are contracts involving the simultaneous sale and future repurchase of an asset, most often Treasury securities.  Typically, the seller buys back the asset at the same price at which it sold. On the buy-back date, the original seller pays the original buyer interest on the implicit loan created by the transaction.  Interest due on a repo at maturity is at the rate for the stated maturity of the repo.

A reverse repo, or simple a reverse, is a contract in which a repo is structured so that a broker/dealer, a bank, or another party that normally uses the repo market to fund (finance) itself is cast in the role of securities purchaser and money lender  Broker/dealers often cover shorts by reversing in securities.

A sell/buyback is essentially the same as a repo, except for the treatment of coupon interest. Coupon payments are not forwarded to the investor by the counterparty. Instead, the counterparty pays the investor repo interest on the coupon payment. When the sell/buyback terminates, the investor will receive its accrued coupon interest from the counterparty. A sell/buy back transaction also differs from a repo transaction in that the sales price for securities delivered differs from the purchase price paid when the securities are returned.  The difference in the price of the sale and purchase transactions accounts for the amount of accrued coupon interest earned and the financing cost charged during the term of the loan.

A buy/sellback is similar to a reverse repo.

The most significant use for the repo market is for investors and dealers to fund long positions and to cover short positions.  Repos offer leveraged investors a source of short-term cash through these collateralized transactions.  The collateralization of these trades provides investors high liquidity and limited credit risk.  If an investor wishes to go long a security, the repo market is a way to borrow the cash (“finance the position”) for that transaction at attractive rates and with little or no margin costs.  The investor who wishes to go short a security can also use the repo market and borrow to cover the short (reverse repo the security).  The investor in this case will earn repo interest on the cash lent against the borrow of the security.

On a repo, the repo interest is the interest charge that an investor pays to the repo broker/dealer on the cash borrowings from the repo dealer. On a reverse repo, an investor receives this interest income for the cash portion it has lent out to the repo dealer.

The rate of interest paid on borrowed money within a particular repo depends principally on what interest rates prevail in the maturity range of the repo (overnight, one week, etc.)  The repo rate does not depend on the yield offered by the underlying security.  The repo rate is negotiated at the time of the transaction; on open trades, the rate is renegotiated daily. The fee is due upon termination, re-price, or partial return of the repo.

A sell/buyback is akin to a repo, except the beneficial ownership transfers to the buyer for the life of the transaction. The repo interest is not charged separately. Rather, it is added to the buyback price of the collateral (i.e. it is a spread above the price change in the collateral for the period). A buy/sellback works in a similar way in place of a reverse repo.  Buybacks and sellbacks are characteristic of transactions involving foreign government collateral.

On a repo, the coupon interest is the interest earned by an investor on the collateral placed at the repo dealer.  If a coupon is paid during the life of the repo, the repo dealer forwards that coupon to the investor.  The repo dealer pays any remaining accrued interest on the collateral to the investor when the repo terminates.  Reverse repos, not surprisingly, have reversed cash flows.

On a sell/buyback, the repo dealer collects the coupon payment, but does not forward it to the investor. Instead, the dealer keeps the coupon, and pays repo interest to the investor on the coupon amount. When the investor buys back the collateral from the repo dealer, it adjusts the purchase price to account for the coupon interest paid plus accrued. The cash flows are reversed for a buy/sellback.

When the value of (accrued interest/face value) is added to the price of the principal, one obtains the full price (or dirty price) of the security.  Repos are full priced.  The carry on a repo or reverse repo transaction is the coupon interest income arising from a long/short position less the repo interest expense.

The price of collateral instruments will vary over time. An investor may experience a gain or a loss (or break-even) on collateral instrument due to price variation. This amount is termed the counterparty repo exposure.

For term repos (not overnight repos), the unrealized gain/loss on repo rate is the difference between a repo’s established rate and the current repo rate, multiplied by the size and age of the repo. When a term repo terminates, this gain/loss always goes to zero.

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Copyright 2011 Eric Bank, Freelance Writer

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