What One Needs to Know about REPO
This article is dedicated to REPOs – repurchase agreements – and all about them: their specifics, pros and cons, risks, and how to avoid them.
What is REPO?
A REPO, also known as a repurchase agreement, is an agreement to sell securities that requires their repurchase at a certain price after a certain period of time. Such an arrangement allows sellers to borrow money fairly quickly.
REPO consists of two parts:
The owner of the security sells it to the buyer for a specified period of time and assumes the obligation to repurchase it when that term expires. The parties agree on the period and amount of the repurchase in advance.
At the end of the term, the buyer returns the securities to the seller and gets their money back plus a commission fee.
As a result, a REPO contains two agreements: an operation involving securities and a futures contract.
REPO Terms
The agreement determines the type, category and amount of assets sold.
Asset price is agreed.
The terms of the agreement or payment of the second part of the REPO are determined. The terms of the second part of the agreement may be specified as “on request”.
The terms of the transfer of securities from one party to another are determined.
REPO Benefits
Sellers can quickly borrow money at market rates without having to go to the bank. In addition, the operation itself did not last long.
Buyers can benefit from short-term placements of free cash without the risk of losing it as they will receive the securities in return. If the seller refuses to repurchase the asset, the buyer is free to sell it on the exchange and get the money back.
Lack of REPO
First, REPOs tend to be short-term agreements, usually limited to one or two years. In practice, they are signed for a shorter period of time. Second, if the market situation changes, one of the parties may refuse to enter into the agreement.
In other words, the seller may refuse to repurchase the security at the agreed price if the market price has fallen, or the buyer may refuse to redeem it if the market price of the asset has risen.
Are there any risks with REPO?
One of the risks is the decline in the market price of securities purchased by buyers. In such a case, the seller may refuse to enter into the second part of the agreement and never repurchase the asset.
The seller must either get rid of the security at a lower price and suffer a loss, or leave it in the portfolio and wait for the price to rise.
Another risk is the increase in the price of the security, so the buyer may refuse to return it.
It may also happen that the buyer does not have the required collateral when the REPO expires. For example, they might sell it for a better price. The buyer may refuse to return the assets to the seller at any time for various reasons, including bankruptcy.
How to reduce the risk of REPO
REPOs provide risk reduction methods such as discounts, compensation and margin fees, revaluations and the ability to redeem a number of different securities.
The discount is the difference between the current price of the security and the REPO amount. The discount depends on the liquidity of the instrument, represented as a percentage of the contract amount and an additional guarantee that the seller will repurchase the securities.
The cost of compensation is the money given to one of the parties if the price of the asset changes.
The liability is remeasured at the request of one of the parties if the price of the asset changes.
If the asset price rises or falls, either party may request the other party to settle the resulting difference in cash or in another number of shares equal to the agreed number of shares.
The marginal cost of giving money or securities to one party to minimize the risk of the other party not complying with the terms of the agreement.
Who receives dividends from shares in REPO
All income from securities – dividends, coupons, etc. – belongs to the seller because he owns the shares. The buyer receives the securities as temporary security. Therefore, the buyer must deliver any proceeds from the securities to the seller.
The agreement may also have other terms, e.g. B. that the buyer may receive a dividend in exchange for the seller, but the price of the security will decrease.