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The terminology related to repo is often confusing to those not involved in the money market. The term repurchase agreement applies to the seller of the agreement. He agrees to repurchase the security. The buyer of the agreement, on the other hand, is doing a resale agreement. He agrees to resell the security to the maker of the agreement.
Synonyms for the repurchase agreement are buy-back agreement (point of view of the maker) and sell-back agreement (point of view of the buyer). Repurchase agreements are also frequently referred to warehousing transactions. The seller is doing a warehousing transaction and the buyer is warehousing an asset.
Terminology also used by some participants is repo-in and repo-out. The former is a resale agreement and the latter a repurchase or buy-back agreement. Both makers and buyers, however, sometimes use the word carry. The maker would say he is having securities carried, while the buyer would say he is carrying securities.
The terminology used by the many central banks in their accommodation procedures and open market operations is also a challenge. They generally accommodate the banks by doing repos at the KIR. What the central banks are actually doing are resale agreements with the banks. The banks are doing repurchase agreements with the central banks.
At times central banks sell securities to the banks to "mop up" liquidity, i.e. to increase the money market shortage. They refer to these as reverse repos. In fact, they are not reverse repos from the central bank's point of view; they are repos.
Similarly, when the central bank sells foreign exchange to the banks in order to "mop up" liquidity, it says it does forex swaps with the banks. This is true, but the transactions may be seen to be repurchase agreements with the banks in foreign exchange at the money market rate, less the relevant foreign interest rate for the term of the repo. This is discussed in detail later.
The majority of participants and certainly the central bank mainly use the term repo, and we will acquiesce in this regard, but use the correct terminology where appropriate to avoid confusion.
Figure 6 provides an example of a repo deal. A bank has in portfolio a LCC10 million NCD of another bank that it is holding in order to make a capital profit when rates fall. The NCD had 360 days to maturity when it was purchased. It is now day 30 in the life of the NCD (i.e. it has 330 days to run), and the bank needs funding for a particular deal that has 70 days to run. The bank sells the NCD to a party that has funds available for 70 days under agreement to repurchase the same NCD after 70 days. The rate agreed is the market interest rate for 70days.
Figure 6: example of 70-day repo in NCDs
Motivation for repos
One of the main reasons which give rise to repos is best described by way of an example. A client of a broker-dealer may wish to invest LCC50 million for a 7-day period. If the broker-dealer cannot find a seller of securities with a term of 7 days, he will endeavour to find a holder of securities who requires funds for this period. If the rate for the repurchase agreement can be agreed, the broker would effect a resale agreement with the seller of the securities and a repurchase agreement with the buyer.
Another way of putting this is that the seller is having the broker carry his securities for a period, while the broker is having these same securities carried by the buyer for the same period. Another reason which gives rise to repurchase agreements is holders of securities requiring funds for short-term periods.
Yet another transaction that gives rise to a repo is the taking of a position in a security. For example, a speculator who believes that bond rates are about to fall (say in the next week) would buy, say, a 5-year bond to the value of, say, LCC5 million at the spot rate of, say, 9.5% (the consideration of course will not be a nice round amount). He does not have the funds to undertake this transaction, but has the creditworthiness to borrow this amount in the view of a broker-dealer. The speculator would thus immediately sell the bond to the broker-dealer (who is involved in the repo market) for 7 days at 10.2% pa (the rate for 7-day money). The broker-dealer in turn would on-sell the bond to, say, a pension fund for 7 days at, say, 10.0% pa.
Figure 7: cash and security flows at onset of repo
Assume now that the 5-year bond rate falls to 9.4% on day seven. The broker-dealer unwinds the repo deal and pays the pension fund LCC5 million plus interest at 10% for 7 days (LCC5 000 000 x 7 / 365 x 0.10 = LCC9 589.04). The broker-dealer then sells the bond back to the speculator for LCC5 million plus interest at 10.2% (LCC5 000 000 x 7 / 365 x 0.102 = LCC9 780.82). The broker's profit is 0.2% on LCC5 million for 7 days (i.e. the difference between the two above amounts (LCC191.78). The speculator sells the bond in the bond market at 9.4% (remember he bought it at 9.5%). His profit on the 5-year-less-7-days bond is 0.1% (which is probably around LCC50 000 - we assume this), i.e. the consideration on the bond is LCC5 000 000 + LCC50 000 = LCC5 050 000. His overall profit is thus LCC50 000 minus the cost of the carry (LCC9 780.82), i.e. LCC40 219.18.
This deal may be depicted as in Figures7-8.
Figure 8: cash and security flows on termination of repo
It will be evident that the speculator sold his bond position to the broker under repurchase agreement for 7 days (or had them carried for this period). The broker did a resale agreement for 7 days with the speculator (or carried the bonds), and a repurchase agreement with the pension fund (or had the bonds carried by the pension fund). The pension fund did a resale agreement with the broker, or carried the bonds for 7 days.
Another rationale for the repo market is the interbank market. This is covered in the following section.
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