What is a Repurchase Agreement (Repo)?
A repurchase agreement is the sale of a security combined with an agreement to repurchase the same security at a higher price at a future date. It is also referred to as a "repo."
How Does a Repurchase Agreement (Repo) Work?
For example, trader A may sell a specific security to trader B for a set price and agree to buy back the security for a specified amount at a later date. In actuality, however, the sale is not a real sale, but rather a loan, secured by the security. As with collateralized loans, the security being used as collateral is "held" by trader B (in case trader A defaults and does not repayment the amount to trader A.) The incremental amount to be repaid by trader A to repurchase the security is the amount of "interest" earned on the loan by trader B.
Repos are usually very short term transactions, mostly with overnight terms although some extend for a period of years. For short term repos, the risks are very low. For longer long repos, with the possibility of fluctuations in the market, collateral risk is much higher.
Why Does a Repurchase Agreement (Repo) Matter?
Repurchase agreements have grown into a very large portion of the money markets, fueling the growth of short-term markets for mutual funds in trading government-backed securities, such as T-bills. Indeed, the Treasury, through its Federal Reserve bank banking system, is a large purchaser of repos, providing important liquidity for short-term market traders.