A repurchase agreement, also known as a repo, is an agreement between two parties where one party sells a security to another party with the promise to buy it back at a later date. It is a short-term loan where the seller (borrower) provides collateral to the buyer (lender) in exchange for cash for a period typically ranging from overnight to several weeks.
Repurchase agreements are commonly used by financial institutions, such as banks and broker-dealers, to raise short-term funds. They are also used by the Federal Reserve as a tool for implementing monetary policy.
In a repurchase agreement, the seller agrees to repurchase the security at a specified price. The buyer earns interest on the cash loaned to the seller, which is typically based on a benchmark interest rate like the federal funds rate. The interest earned by the buyer is known as the repo rate or the repo yield.
The collateral provided by the seller is typically a government bond, or other high-quality securities. The collateral serves as a security for the loan and provides some protection to the lender in case the borrower defaults on the loan.
Repurchase agreements are typically structured as a sale and a forward contract. The sale of the security provides the lender with legal ownership, while the forward contract provides the lender with the right to sell the security back to the borrower at a predetermined price and date.
The economic impact of repurchase agreements is significant. They provide a source of short-term funding for financial institutions, which can help them meet temporary financing needs. The use of repurchase agreements by the Federal Reserve can also influence the supply of money in the economy and help control inflation.
In conclusion, a repurchase agreement is an important financial transaction used by both financial institutions and the Federal Reserve. It provides short-term funding for financial institutions and helps the Fed implement monetary policy. Understanding the economic implications of repurchase agreements is important for anyone interested in finance and economics.