Money Market Funds Investments – Repos

Repo is the shortened term for repurchase agreement.  Repurchase agreements are financial instruments used in money markets and capital markets as a form of overnight borrowing.  A repurchase agreement involves a short-term sale and subsequent repurchase of securities by a bank or other financial institution.  They are most frequently completed with government securities but other debts instruments are used as well.  The initial sales and the repurchase are made at the same dollar price with an agreed upon rate of interest paid to the initial buyer by the seller at the time of repurchase after a specified period of time.

A standard repurchase agreement involves a dealer or other holder of government securities who sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price.  They are lent out at an interest rate referred to as the repo interest rate.  The repo rate is the difference between borrowed and paid back cash expressed as a percentage.  They are usually very short-term, from overnight to 30 days or more.  This short-term maturity and government backing means repos provide lenders with extremely low risk. For the buyer, a repo is an opportunity to invest cash for a customized period of time.  It is short-term and safer as a secured investment since the investor receives collateral. 

The repo actually involves both a sale and repurchase agreement, since the borrower sells securities for cash to a lender and agrees to repurchase those securities at a later date for the initial price plus a premium.  A repo is financially similar to a secured loan, with the buyer receiving securities as collateral to protect against default.  Most any security can be utilized in a repo, government debt is the most liquid, credit worthy and abundant to use.

Repos are popular because they are generally very short term and have extremely low credit risk.  The legal title to the securities clearly passes from the seller to the buyer, or investor.  Market liquidity for repos is good, and rates are competitive for investors.  Money market funds are large buyers of repurchase agreements.

A variation of the standard repo is a reverse repo.  The reverse repo is the complete opposite of a repo.  In these circumstances, a dealer buys government securities from an investor and then sells them back at a later date for a higher price.  A reverse repo is basically the same repurchase agreement but from the buyer’s viewpoint, not the seller’s.  Consequently, the seller executing the contract would describe the transaction as a repo, while the buyer in the same transaction would describe it a reverse repo.  Hence repos and reverse repos are fundamentally the same operation, just express from opposing perspectives.

When a repurchase agreement is initiated, the dealer or bank issues a confirmation of the sale of the securities to the customer and a second confirmation of the bank’s obligation to repurchase them at the maturity date.  There can be at least three categories of repo maturity dates.  Overnight repos, term repos, and open repo maturities.  Overnight refers to a one day maturity transaction.  Open simply has no end date.  The term repo refers to the the term of the loan being a time period greater than 30 days. Term repos will have a defined end date.   Even though repos are typically short term transactions, it is not abnormal to construct repos with maturities as long as two years.

This entry was posted on Tuesday, January 6th, 2009 at 1:29 pm and is filed under Mutual Funds. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.