A repurchase agreement involves selling collateral to a lender in exchange for a loan, with the borrower regaining control of the collateral once the loan is repaid. Interest is earned by the lender during this time, and the agreement can be structured in various ways with different types of securities used as collateral.
Also known as a repurchase agreement, a repurchase agreement is a strategy for acquiring a loan from a lender that involves the sale and repurchase of an asset or security. Essentially, the lender agrees to make the loan, with the understanding that the borrower will sell the collateral to the lender. At a later agreed date, the borrower will regain control of the collateral, once the loan has been paid in full.
In actual process, repurchase agreements work much like any cash loan transaction, but add the basic approach that involves executing a forward contract. Funds are transferred from the lender to the borrower. Simultaneously, the borrower transfers ownership of the collateral to the lender. The settlement date identified in the dual transaction also functions as the loan due date.
During the time the lender is in control of the security, he or she earns interest on the transaction. The actual amount of interest is calculated by determining the difference between the forward price and the spot price. Assuming the borrower repays the loan in full before the due date, interest stops accruing at that payment point.
A repurchase agreement can apply to a single transaction between the borrower and the lender, or set up a series of transactions, all using this strategy. Sometimes called a master repurchase agreement, the lender and borrower agree to a rolling schedule of loans and repayments, with the agreed values used as collateral. This cash creates an ongoing reverse repurchase agreement, as the same security may change ownership multiple times during the life of the master agreement.
It is possible to structure a repurchase as an overnight transaction, effectively completing the entire cycle within a twenty-four hour period. Other agreements of this type can also be arranged with a specific expiration date, which can range from several days to a month or more. It’s even possible to structure what’s known as an open deal, which means the expiration date isn’t set in stone. Essentially, this means that the seller has the guarantee and gets a return until the buyer has paid the face amount of the loan.
The type of security used for a single or reverse agreement strategy may vary, depending on the financial regulations established by the country of jurisdiction. The contract can be created as a share repurchase agreement, using shares of shares. With a bank repo agreement, it may also be possible to use government-issued bonds or coupons as collateral. Brokers and financial advisors associated with banking and finance companies will know what types of securities can currently be used as collateral and will advise both the buyer and the seller.
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