Understanding the value of Repos

For the uninitiated, repo or repurchase agreement refers to an agreement where securities (usually government bonds, treasury bills) are sold with a promise that they’ll be bought back at a specified time and price. Since these are repurchased, they are called repo agreements. Through a repo agreement, a party that either requires cash or the bonds exchanges it for compensation for the temporary use of the asset. The title is only transferred for a fixed period of time and the seller retains the benefits and risks of owning the bond. Repos are beneficial for investors looking for a secured investment.

To explain the concept further let us understand how a typical repo trade works. A trader A buys an asset from the cash market at an outright price. He then borrows money for the purchase, by selling the asset he just purchased, to the repo market. The money generated from this sale is used to finance the payment of the asset. But this is not a permanent sale and the seller promises to repurchase it at an agreed price at a future date. Even though the asset is sold the value of the repo during the term of the repo shall be a loss or profit to the seller depending upon the price of the asset and the price that was fixed at the beginning of the agreement. The buyer holds the asset as collateral, i.e. if the seller defaults on his payment the asset will be sold to recover the cash. The agreement also gives the buyer to reuse the repo, as in sell them outright, or pledge them to a third party. Usually a repo party is sold and bought back at the same right (also called the classic repo) in addition to the repo interest. But sometimes the liquidity of the market and the quality of the seller can cause the buyer to quote a price that is lower than the market price, by deducting an initial margin.

The repo interest mentioned earlier is also called repo rate and is determined by the market and is often lower than other deposit rates because of the repo (in its character of a collateral ) is less risky. In Turkey, The Central Bank (which is the apex bank there) provides a bench mark for the repo rate.

A number of dealers deal with repo trades because of the relatively lower credit risk involved. Also there is equal demand for the supply and demand for repos. When buyers anticipate that vales for the instruments will fall they usually sell assets that they don’t have and expect to buy back later for a lower price and make profit.

Repos are often used by Central banks in different countries to control short term interest rates in the open market.