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What is a repurchase agreement (repo loan)?
A repurchase agreement, also known as a repo loan, is an instrument for raising short-term funds. With a repurchase agreement, financial institutions essentially sell securities from someone else, usually a government, in an overnight transaction and agree to buy them back at a higher price at later date. The security acts as collateral for the buyer until the seller can pay the buyer back, and the buyer earns interest in return.
Repurchase agreements allow the sale of a security to another party with the promise that it’ll be purchased again later at a higher price. The buyer also earns interest.
With a repurchase agreement being a sell/buy-back type of loan, the seller acts as the borrower and the buyer as the lender. The collateral refers to the securities sold, which usually originate with the government. Repo loans provide quick liquidity.
The assets are meant to be sold right away, unlike a secured deposit. Although repo loans are safe because they’re backed by government securities, there is a risk that the securities will drop in value, hurting the buyer’s investment.
With an overnight repo loan, the agreed duration of the loan is one day. However, either party can extend the maturity period, and occasionally the agreement has no maturity date at all.
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Repurchase agreement example
Financial Services Inc., an investment bank, wants to raise some cash to cover its operations. It partners with Cash ‘n’ Capital Bank to purchase $1 million of U.S. Treasury bonds, with Cash ‘n’ Capital paying $900,000 and Financial Services Inc. receiving the $1 million in bonds. When the repo loan matures, Cash gets $1 million plus interest, and Financial owns securities worth $1 million.