What One Needs to Know about REPO
This article is devoted to REPO — Repurchase Agreements — and everything about them: their peculiarities, advantages and drawbacks, risks and how to avoid them.
REPO, aka Repurchase Agreement, is an agreement on selling securities that presumes their obligatory buyback at a certain price after certain time. Such agreements let the seller loan money quite fast.
A REPO consists of two part:
- The owner of securities sells them to the buyer for a certain term and takes on the responsibility to buy them back as soon as the term ends. The term and the sum of the buyback are agreed upon by the parties beforehand.
- When the term ends, the buyer is to give the securities back to the seller, receiving their money plus commission fee is exchange.
As a result, a REPO has two agreements inside: an operation with securities and a forward contract.
- The agreement specifies the type, category, number of sold assets.
- The price of the asset is agreed upon.
- The terms of the agreement or payments of the second part of the REPO are specified. The terms of the second part of the agreement can be set as "on demand".
- Terms of passing the securities from one party to the other are specified.
- The seller can loan money quickly on market conditions without addressing a bank. Moreover, the operation itself does not take long.
- The buyer can make a profit on short-term placement of free cash without the risk of losing it because they get securities in exchange. If the seller refuses to buy back their assets, the buyer can sell them freely in the stock market and get back their money.
Firstly, REPOs are rather short-term agreements, normally limited by a year or two. In practice, they are signed for a shorter time. Secondly, if the market situation changes, one of the parties can refuse to follow the agreement.
In other words, the seller can refuse to buy back their securities at the agreed price if the market price has dropped, or the buyer can refuse to give them back if the market price of the asset has grown.
One of the risks is falling of the market price of the securities that the buyer has bought. In such a case, the seller can refuse to complete the second part of the agreement and never buy back the asset.
The seller will have to get rid of the securities at a lower price and suffer losses, or leave it in the portfolio and wait for the price to grow.
Another risk is the growth of the security price, so that the buyer can refuse to give them back.
Moreover, it might so happen that at the REPO expiry the buyer will have no necessary securities available. For example, they might have sold them at a better price. The buyer may always refuse to give the asset back to the seller for various reasons including bankruptcy.
The REPO features such methods of decreasing risks as discount, compensation and margin fees, revaluation, and the opportunity to return a different number of securities.
- Discount is the difference between the current securities price and the REPO sum. Discount depends on the liquidity of the instrument, is represented in percent of the sum of the agreement, and additionally guarantees that the seller will buy the securities back.
- Compensation fee is the money passed to one of the parties in case the price of the asset changes.
- Revaluation of obligations happens on requirement of one party in case the price of the asset changes.
- If the asset price grows or falls, one party may demand that the other one compensates for the emerging difference in cash or a different number of securities, equivalent to the agreed number of securities.
- Marginal fee is giving money or securities to one of the parties to minimise the risk that the other one will fail to follow the terms of the agreement.
All income from the securities — dividends, coupons, etc. — belongs to the seller because they own the shares. The buyer receives the securities as a temporary guarantee. That is why the buyer must pass all the income from the securities to the seller.
Also, the agreement can have other conditions, such as the buyer can receive dividends instead of the seller but the security price will fall accordingly.
A market player has 100 shares of a company, 10 USD each. At a certain point, they need money, and they find a buyer ready to buy 100 shares right now but for 8 USD each.
Signing a REPO, the buyer agrees on selling (or returning) 100 shares for 8 USD each plus 10%. When the contract expires, the seller buys their shares back at the said price. As a result they got a loan for 10% a year, and the buyer got their money back and earned 10% of the whole sum.
REPOs can seriously facilitate the development of a company or private investor. However, risks of such contracts must not be neglected. For example, one of the parties can fail to follow the agreement.
On the other hand, both parties of a REPO are in more or less mutually profitable conditions. Signing such a contract, it is absolutely necessary to weight up all drawbacks and pluses in advance and study the market situation of the asset in question.
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