Post on 14-Jun-2015
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FATIMA JINNAH WOMEN UNIVERSITYASSIGNMENT
ESSENTIAL OF BANKING MANAGEMENT
REPOSREPURCHASE AGREEMENT
INTRODUCTION
Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset
On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds
They are usually very short-term, from overnight to 30 days or more than 30 days sometimes
DEFINITION
“A contract in which the seller of securities, such as Treasury Bills, agrees to buy them back at a specified
time and price.”
HISTORY
In US, repos have been used from as early as 1917 when wartime taxes made older forms of lending less attractive
First repos were used just by the Federal Reserve to lend to other banks
After fell away through the Great depression and WWII in 1920s, repos then expanded once again in the 1950s
Rapid growth in the 1970s and 1980s in part due to computer technology
EXPLANATION
The annualized rate of interest paid on the loan is known as the repo rate
Repos for longer than overnight are known as term repos.
repos that can be terminated by either side on a day’s notice are known as open repos
the seller of securities does a repo and the lender of funds does a reverse
EXPLANATIONThe overnight repo rate normally runs slightly
below the Fed funds rate for two reasons: First a repo transaction is a secured loan, whereas the sale of Fed funds is an unsecured loan.Second, many who can invest in repos cannot sell Fed funds
By rolling overnight repos, they can keep surplus funds invested without losing liquidity or incurring price risk
They also incur very little credit risk
Repos are classified as a money-market instrument
They are usually used to raise short-term capital
STRUCTURE AND TERMINOLOGY
A repo is economically similar to a secured loan
Highly liquid securities are preferred as they are more easily disposed of in the event of a default
Collaterals used in a repo transaction are:Treasury billsCorporate and Treasury/Government bondsStocks
Securities are resold and coupons are paid to the seller (borrower) at end of agreement
STRUCTURE AND TERMINOLOGY
TYPES OF REPURCHASE AGREEMENT
Term: Term refers to a repo with a specified end date. Open repo:
Open simply has no end date. In these agreements the buyer (the cash lender) or seller (a collateral provider) can terminate the repurchase agreement at any time.
IMPORTANCE OF REPOS
Repos are similar to Federal Funds except that Non-Banks can participate
Repos are utilized by central banks as an indirect instrument of monetary control for absorbing or injecting short term liquidity.
Fed buys or sells Treasury securities in the repo market to adjust the bank reserves.
FORMS OF REPOS
Specified delivery:It requires delivery of the bond at the start and at maturity of agreement.
Held in custody:A repo in which securities sold are held in custody by the seller for the buyer until maturity.
Buy-sell repo:In a buy-sell repo the ownership is passed on to the buyer and hence he retains any coupon interest due on the bonds.
• Tri-party: REPO
INVESTMENT DATE
INVESTOR (Money Market Fund)
1. Cash balance sent to custodian
TRI-PARTY
SECURITIES
AGENT
2. Dealer sends eligible securities
to custodian
3. Agent releases cash to dealer
REPO
DEALER
FORMS OF REPOS
FORMS OF REPOS
REPO MATURITY
DATE
INVESTOR (Money Market Fund)
6. Agent returns cash & interest
to money market fund
TRI-PARTY
SECURITIES
AGENT
TRI-PARTY
SECURITIES
AGENT
4. Dealer returns cash & interest at end
of term
5. Agent sends eligible
securities to the dealer
REPO
DEALER
MAJOR BORROWERS AND LENDERS
Borrowers:Government bond dealers of Treasuries Large banks
Lenders:State and local governmentsInsurance companiesLarge banksNon-financial corporations
REPO INTEREST INCOME
The difference between the underlying securities current price and repurchase price is the amount of interest paid by the borrower to
the lender.
HOW REPURCHASE AGREEMENTS WORK
Why the owner sells bond to someone and repurchase it at higher price?
The securities owner may need cash for a day or two, or a week or more.
Instead of taking out a short-term loan, he can sell the bond or stock to someone and promise to buy it back at a higher price.
Why would anyone want to own a security for such a short time?
Consider a money-market fund with excess cash that it needs to keep safe and provide a decent return on.
Its managers may be willing to transfer some of the cash for a short time in exchange for a higher-yielding security, such as a Treasury bond.
REPO MARKET
The over-the-counter repo market is now one of the largest and most active sectors in the US money market
Dealers in securities use repos to manage their liquidity, finance their inventories, and speculate in various ways.
REPO MARKET PLAYERS
InvestorsBorrowersOther institutions
REPO ARE NOT FOR SMALL INVESTORS
The largest users of repos and reverses are the dealers in government securities.
As of June 2008 there were 20 primary dealers recognized by the Fed.
Many dealers do repos and reverses in at least one million dollar chunks.
Big suppliers of repo money are money funds, large corporations, state and local governments, and foreign central banks.
WHO ELSE USES REPURCHASE AGREEMENTS
Central banks use repurchase
agreements to increase or reduce
the money supply. Companies, especially banks, may participate in repo markets to make productive use of cash on their balance sheets.
Repos are considered to be particularly safe, because the loan comes with collateral.
REVERSE REPOS
“A purchase of securities with an agreement to resell them at a higher price at a
specific future date.“This is essentially just a loan of the security at a specific
rate.
Reverse repo is exactly the opposite of repo – a party buys a security from another party with a commitment to sell it back to the latter at a specified time and price.
The difference between the price at which the securities are bought and sold is the lender’s profit or interest earned for lending the money.
The terms of contract are in terms of a ‘repo rate’, representing the money market borrowing/lending rate.
(Repo rate is the annual interest rate for the funds transferred by the lender to the borrower.)
REVERSE REPOS
USES OF REPOS
For the buyer, a repo is an opportunity to invest cash for a customized period of time.
For traders in trading firms, repos are used to finance long positions.
Securities dealers are primary users of overnight repos.
The Federal Reserve also uses repos for open market operations where they add or decrease reserves to the banking system by trading in US Treasury Securities.
Although repo transactions are backed by collateral, i.e. the lender can sell the securities to redeem the cash, a counter-party risk exists.
In addition to using repo as a funding vehicle, repo traders "make markets“. These traders have been traditionally known as "matched-book repo traders”.
The concept of a matched-book trade follows closely to that of a broker who takes both sides of an active trade, essentially having no market risk, only credit risk.
USES OF REPOS
RISK INVOLVE IN REPOS
Repurchase agreements, known as Repos, involve the sale and purchase of an asset at the same time. The assets used for Repos are usually U.S. Treasury securities.
Repos are essentially short-term loans that banks use to fund daily and weekly operations, and the risks involved include both credit risk and market risk.
BUYER’S CREDIT RISK
The buyer in a Repo transaction incurs credit risk when the deal is executed. If the seller, or counterparty, to the trade goes bankrupt before the Repo matures, then the buyer will be left holding the securities underlying the Repo trade.
BUYER’S MARKET RISK
Market risk in the context of Repos means interest rate risk. If the counterparty to the deal goes bankrupt before maturity, then the Repo buyer is exposed to the market risk caused by changes in interest rates.
SELLER’S CREDIT RISK
The seller in a Repo trade also has credit risk. If the counterparty goes bankrupt before the trade matures, then the securities that were loaned to the buyer might get stuck in bankruptcy proceedings and not returned to the seller.
SELLER’S MARKET RISK
In a mirror image of the market risk that the buyer assumes in a Repo deal, the seller can lose money if interest rates decline before maturity. If the buyer goes bankrupt, then the seller has an amount of cash that will be lower than the value of the securities that were loaned at the start of the trade.
CONCLUSION