What is Repo (Repurchase Agreement)?
A repo (repurchase agreement) is a short-term contract between two parties. In this accord, one party agrees to sell a security to the other and buy it back after a slightly higher price. The seller gets money from the buyer, and the security acts as a guarantee for the deal. The difference between the first and the last prices decides the interest rate, called the repo rate, for the loan. Repurchase agreements are mainly used to raise short-term money or to affect the amount of money in the economy, especially by central banks.
Repo Explained
A repo, or a repurchase agreement, is a brief transaction where one party sells a security to another and pledges to repurchase it later at a greater price. The length of a repo can range from one day to one year. Repos that do not have a set maturity date are called “open” repos, while those that have a fixed maturity date are known as “term” repos.
Basically, a repo acts as a way for a seller to get money from a buyer by using a security as a guarantee. The seller transfers the security to the buyer and agrees to buy it back later at a prearranged price. The interest, or repo rate, is decided by the difference between the first and the last prices, showing the cost paid by the seller to the buyer. Moreover, a repo works as a forward contract, meaning an agreement to trade a security at a prearranged future date and price.
Understanding the Legs of a Repurchase Agreement
Repurchase agreements, or repos, are a type of short-term borrowing and lending of government securities for dealers and investors. They use some special terms that are not widely used in other areas of finance. One of these terms is the “leg,” which refers to a part of the repo transaction. There are two main types of legs: the “start leg” or “near leg,” where the borrower sells the security to the lender, and the “close leg” or “far leg,” where the borrower buys back the security from the lender.