What Is a Term Repurchase Agreement?
Under a term repurchase agreement (term repo), a bank will agree to buy securities from a dealer and then resell them back to the dealer a short time later at a pre-specified price. The difference between the re-purchase and sale prices represents the implicit interest paid for the agreement.
Term repurchase agreements are used as a short-term financing solution or cash-investment alternative with a fixed term lasting from overnight to a few weeks to several months.
- Term repurchase agreements are used by banks (i.e. lenders) to buy securities and then resell them later at an agreed-upon price.
- The borrower repays the money and the interest at the repo rate at the end of the term.
- These repo agreements, which can be overnight or a term of a few weeks or months, are used to raise short-term capital.
How a Term Repurchase Agreement Works
The repurchase, or repo, market is where fixed income securities are bought and sold. Borrowers and lenders enter into repurchase agreements where cash is exchanged for debt issues to raise short-term capital.
A repurchase agreement is a sale of securities for cash with a commitment to buy back the securities on a future date for a predetermined price—this is the view of the borrowing party. A lender, such as a bank, will enter a repo agreement to buy the fixed income securities from a borrowing counterparty, such as a dealer, with a promise to sell the securities back within a short period of time. At the end of the agreement term, the borrower repays the money plus interest at a repo rate to the lender and takes back the securities.
A repo can be either overnight or a term repo. An overnight repo is an agreement in which the duration of the loan is one day. Term repurchase agreements, on the other hand, can be as long as one year with a majority of term repos having a duration of three months or less. However, it is not unusual to see term repos with a maturity as long as two years.
Benefits of a Term Repurchase Agreement
Banks and other savings institutions that are holding excess cash quite often employ these instruments, because they have shorter maturities than certificates of deposit (CDs). Term repurchase agreements also tend to pay higher interest than overnight repurchase agreements because they carry greater interest-rate risk since their maturity is greater than one day. Furthermore, the collateral risk is higher for term repos than overnight repos since the value of the assets used as collateral has a higher chance of declining in value over a longer period of time.
Central banks and banks enter into term repurchase agreements to enable banks to boost their capital reserves. At a later time, the central bank would sell back the Treasury bill or government paperback to the commercial bank.
By buying these securities, the central bank helps to boost the supply of money in the economy, thereby, encouraging spending and reducing the cost of borrowing. When the central bank wants the growth of the economy to contract, it sells the government securities first and then buys them back at an agreed-upon date. In this case, the agreement is referred to as a reverse term repurchase agreement.
Requirements for a Term Repurchase Agreement
The financial institution that purchases the security cannot sell them to another party, unless the seller defaults on its obligation to repurchase the security. The security involved in the transaction acts as collateral for the buyer until the seller can pay the buyer back. In effect, the sale of a security is not considered a real sale, but a collateralized loan which is secured by an asset.
The repo rate is the cost of buying back the securities from the seller or lender. The rate is a simple interest rate that uses an actual/360 calendar and represents the cost of borrowing in the repo market. For instance, a seller or borrower may have to pay a 10% higher price at repurchase time.