Solana is one of the most popular cryptocurrencies available today. Glossary R Repurchase agreement repo loan Repurchase agreement repo loan A repurchase agreement is a short-term loan to raise quick cash. What is a repurchase agreement repo loan? Other collateralized loans include mortgages. Get a great rate on one today. More From Bankrate What is risk tolerance, and why is it important? What is the long-term capital gains tax? I have been practicing law for 35 years.
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During a longer tenor, more factors can affect repurchaser creditworthiness, and interest rate fluctuations are more likely to have an impact on the value of the repurchased asset. It's similar to the factors that affect bond interest rates.
In normal credit market conditions, a longer-duration bond yields higher interest. Long-term bond purchases are bets that interest rates will not rise substantially during the life of the bond. Over a longer duration, it is more likely that a tail event will occur, driving interest rates above forecasted ranges. If there is a period of high inflation , the interest paid on bonds preceding that period will be worth less in real terms. This same principle applies to repos. The longer the term of the repo, the more likely that the value of the collateral securities will fluctuate prior to the repurchase, and business activities will affect the repurchaser's ability to fulfill the contract.
In fact, counterparty credit risk is the primary risk involved in repos. As with any loan, the creditor bears the risk that the debtor will be unable to repay the principal. Repos function as collateralized debt, which reduces the total risk. And because the repo price exceeds the value of collateral, these agreements remain mutually beneficial to buyers and sellers. There are three main types of repurchase agreements.
Like many other corners of the financial world, repurchase agreements involve terminology that is not commonly found elsewhere. In the near leg of a repo transaction, the security is sold. In the far leg, it is repurchased. When government central banks repurchase securities from private banks, they do so at a discounted rate, known as the repo rate.
Like prime rates , repo rates are set by central banks. The repo rate system allows governments to control the money supply within economies by increasing or decreasing available funds. A decrease in repo rates encourages banks to sell securities back to the government in return for cash.
This increases the money supply available to the general economy. Conversely, by increasing repo rates, central banks can effectively decrease the money supply by discouraging banks from reselling these securities. In order to determine the true costs and benefits of a repurchase agreement, a buyer or seller interested in participating in the transaction must consider three different calculations:.
The cash paid in the initial security sale and the cash paid in the repurchase will be dependent upon the value and type of security involved in the repo.
In the case of a bond, for instance, both of these values will need to take into consideration the clean price and the value of the accrued interest for the bond.
A crucial calculation in any repo agreement is the implied rate of interest. If the interest rate is not favorable, a repo agreement may not be the most efficient way of gaining access to short-term cash. A formula which can be used to calculate the real rate of interest is below:.
Once the real interest rate has been calculated, a comparison of the rate against those pertaining to other types of funding will reveal whether or not the repurchase agreement is a good deal.
Generally, as a secured form of lending, repurchase agreements offer better terms than money market cash lending agreements. From the perspective of a reverse repo participant, the agreement can generate extra income on excess cash reserves as well. Repurchase agreements are generally seen as credit-risk mitigated instruments. The largest risk in a repo is that the seller may fail to hold up its end of the agreement by not repurchasing the securities which it sold at the maturity date.
In these situations, the buyer of the security may then liquidate the security in order to attempt to recover the cash that it paid out initially. Why this constitutes an inherent risk, though, is that the value of the security may have declined since the initial sale, and it thus may leave the buyer with no option but to either hold the security which it never intended to maintain over the long term or to sell it for a loss.
On the other hand, there is a risk for the borrower in this transaction as well; if the value of the security rises above the agreed-upon terms, the creditor may not sell the security back. For example, a bank sells bonds to another bank and agrees to buy the bonds back later at a higher price. A business can engage in similar activity by offering certificates of deposit, stocks and bonds for sale to a bank or other financial institution with the promise to buy back the security at a later date for a higher price.
Under the repurchase agreement, the financial institution you sell the securities to cannot sell them to someone else unless you default on your promise to buy them back. That means you must honor your obligation to repurchase. Failure to do so can hurt your credibility. It also can mean a lost opportunity if the security would have increased in value after your repurchase.
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