Repurchase agreement is a contract wherein the seller of a security agrees to buy back the same security from the purchaser at a specified price and time. It is also known as repo or buyback. The price at which the seller agrees to buy back is known as repurchase price. And the date by which the security is to be repurchased is known as repurchase date. Repurchase agreement can be treated as a collateralized loan, where the collateral is sold and later re purchased. The security acts as collateral in repurchase agreements.
A dealer can use repurchase agreement or 'repo' market to obtain finance by pledging the purchased security as collateral to the loan. The interest rate the dealer agrees to pay is known as repo rate. The term of the loan, i.e. the date by which the dealer has to buyback the security and the repo rate are specified in the agreement. In an overnight repo, the term of the loan is one day, in a term repo the term of the loan is more than one day. The difference between the buyback price and the sale price is the actual interest cost of the loan.
Amount of interest depends on the repo rate, the term of the loan and the amount borrowed. The formula to calculate interest is as follows:
Interest = Amount Borrowed x Repo rate x Repo term/360.
Illustration
Amount borrowed = Rs.30,00,000
Repo rate = 0.06
Repo term = 1 day
Therefore,
Interest = Rs.30, 00,000 x 0.06 x 1/360 = Rs.500.
Dealers can reduce their cost of funding by using repo market for borrowing funds on a short-term basis. The cost of bank financing is higher than the cost involved while using repo market. To the customer, repo market offers better yield on a short-term loan and the highly liquid nature of the market makes it more attractive.
Reverse repo is an agreement where a buyer purchases securities with an agreement to resell them at a specified price (which is higher than the buying price) on a specified date.