Introduction to repurchase agreement (Repo)
- A repurchase agreement (repo) refers to short-term borrowing for dealers in government securities. In the event of a repo, a dealer sells government securities to investors, normally on an overnight basis, and then buys it back the next day at a slightly higher price. That slight difference in price is the absolute overnight interest rate. Repos are used to get short-term capital. They are also a tool of the central bank's open market operations.
- For the party selling the security and conforming to repurchase it in the future, it is a repo; for the party on the opposite end of the transaction, buying the security and deciding to sell in the future, it is a reverse repurchase agreement.
Understanding Repurchase Agreements (Repo)
Repurchase agreements are usually considered safe investments because the security in question functions as collateral, which is the reason why most agreements involve U.S. Treasury bonds. Listed as a money-market instrument, a repurchase agreement works in effect as a short-term, collateral-backed, interest-bearing loan. The buyer works as a short-term lender, while the seller acts as a short-term borrower. The securities being sold are known to be the collateral. Thus the purposes of both parties, secured funding and liquidity, are met.
Repurchase agreements can take place within a variety of parties. The Federal Reserve enters into repurchase agreements to control the money supply and bank reserves. Individuals normally use these agreements to finance the purchase of debt securities or other kinds of investment. Repurchase agreements are strictly short-term investments, and their maturity period is known as the "rate," the "term", or the "tenor."
How Does Repo Rate Affect The Economy?
- Repo rate is an efficient tool used by the apex bank to regulate and monitor the inflation, liquidity and money supply within the market. The variation in the repo rate can also affect the cost of borrowings by banks.
- In the case of rising inflation, RBI raises the repo rate to control inflation. Once the repo rate rises, the cost of borrowing for businesses rises, reducing down the investment and cash flow in the market.
- If there is a liquidity crunch in the economy, RBI decreases the repo rate, following which the cost of borrowing decreases, increasing the cash flow in the economy.
- It also aids in boosting economic growth and improves the cash available for retail consumers.
