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1. What is a repo?
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Repo is a generic name for both repurchase agreements and sell/buy-backs.*

In a repo, one party sells an asset (usually fixed-income securities) to another party at one price at the start of the transaction and commits to repurchase the fungible assets from the second party at a different price at a future date or (in the case of an open repo) on demand.** If the seller defaults during the life of the repo, the buyer (as the new owner) can sell the asset to a third party to offset his loss. The asset therefore acts as collateral and mitigates the credit risk that the buyer has on the seller.

Although assets are sold outright at the start of a repo, the commitment of the seller to buy back the fungible assets in the future means that the buyer has only temporary use of those assets, while the seller has only temporary use of the cash proceeds of the sale. Thus, although repo is structured legally as a sale and repurchase of securities, it behaves economically like a collateralised loan or secured deposit (and the principal use of repo is in fact the borrowing and lending of cash).

The difference between the price paid by the buyer at the start of a repo and the price he receives at the end is his return on the cash that he is effectively lending to the seller. In repurchase agreements, this return is quoted as a percentage per annum rate and is called the repo rate. Although not legally correct, the return is usually referred to as repo interest.

An example of a repo is illustrated below.




The buyer in a repo is often described as doing a reverse repo (ie buying, then selling).

A repo not only mitigates the buyer’s credit risk. Provided the assets being used as collateral are liquid, the buyer should be able to refinance himself at any time during the life of a repo by selling or repoing the assets to a third party (he would, of course, subsequently have to buy the collateral back in order to return it to his repo counterparty at the end of the repo). This right of use therefore mitigates the liquidity risk that the buyer takes by lending to the seller. Because lending through a repo exposes the buyer to lower credit and liquidity risks, repo rates should be lower than unsecured money market rates.



* Repos are sometimes known as 'sale-and-repurchase agreements'. In some markets, the name ‘repo’ can be taken to imply repurchase agreements only and not sell/buy-backs. Repurchase agreements are also known as 'classic repo'. Repo, along with securities lending, is a type of 'securities financing transaction' (SFT).

** In the Global Master Repurchase Agreement (GMRA), fungible assets are described as ‘equivalent’ assets. Fungible or equivalent, which means an asset that is economically but not necessarily legally identical (usually the same bond issue but not the same part of the issue).



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