Repurchase Agreements (Repos)

AnalystPrep Summary

A repurchase agreement, or repo, is a secured short-term financing transaction in which one party sells securities while agreeing to repurchase them later at a higher price. The difference between the sale price and the repurchase price represents interest on the loan and is reflected in the repo rate.

Because repos are collateralized, they generally carry lower credit risk than unsecured borrowing. They are widely used by banks, dealers, institutional investors, and central banks for liquidity management, short-term funding, collateralized lending, and monetary policy operations.

For CFA Level I candidates, the key is to understand how repo transactions work, how repo rates are calculated, how margins and haircuts protect lenders, and how repos differ from reverse repos.

Repo vs Reverse Repo

Repo	Reverse Repo
Seller borrows cash	Buyer lends cash
Seller provides securities	Buyer receives securities as collateral
Borrower pays repo interest	Lender earns repo interest
Used to obtain liquidity	Used to invest excess cash
Viewed from the cash borrower’s perspective	Viewed from the cash lender’s perspective

This comparison directly targets one of the most common repo-related searches and helps clarify that a repo and reverse repo are opposite sides of the same transaction.

What Is a Reverse Repo?

A reverse repo is the opposite side of a repo transaction. From the lender’s perspective, the transaction is a reverse repo because the lender provides cash and receives securities as collateral.

For example, if Bank A sells securities to Bank B and agrees to repurchase them later, Bank A is entering into a repo. Bank B, which provides the cash and receives the securities, is entering into a reverse repo.

Institutions use reverse repos to invest excess cash on a secured basis. Central banks may also use reverse repos to absorb liquidity from the financial system and help control short-term interest rates.

For CFA candidates, remember that repo and reverse repo describe the same transaction from opposite perspectives.

Key Takeaways

• Repos are collateralized short-term loans.
• The repo seller borrows cash and provides securities as collateral.
• The repo buyer lends cash and receives securities as collateral.
• The repo rate represents the borrowing cost.
• Haircuts protect lenders from declines in collateral value.
• Initial margin determines the relationship between collateral value and loan amount.
• Variation margin adjusts collateral as market values change.
• Reverse repos are the opposite side of the same transaction.
• Central banks use repos and reverse repos to manage system liquidity.
• High-quality government securities are common repo collateral.

Repurchase agreements, commonly known as repos, serve as a secured method for short-term borrowing and lending. These transactions consist of a seller committing to repurchase a security at a predefined price on a future date. This operation essentially allows the seller to obtain a short-term loan collateralized by the security.

The repo transaction starts with the sale of a security and ends with its repurchase. For instance, consider a US five-year Treasury note trading at $150 million. If it’s sold today (t=0) under a 45-day repo term at an annual interest rate (repo rate) of 0.5%, the repurchase price after 45 days would be calculated as:

Assuming that there are 360 days in a year:

$$ 150\times\left[1+\left(0.5\%\times\frac{45}{360}\right)\right]=\$150.094 \text{ million} $$

The security seller effectively gets a short-term loan, collateralized by the US Treasury note. Repos can range from overnight to term repos, which have maturities longer than a day. The most common collateral is highly liquid bonds with minimal credit risk, such as sovereign bonds. A general collateral repo transaction allows a range of securities as eligible collateral.

Understanding Repurchase Agreements (Repos)

Repurchase agreements are among the most important short-term financing instruments in financial markets. They allow institutions to borrow cash using securities as collateral while giving lenders a secured, short-term investment.

A repo is structured as a sale and later repurchase of securities, but economically it functions like a collateralized loan. The borrower receives cash today and agrees to repurchase the securities later at a higher price. The difference between the two prices represents repo interest.

Repos play a critical role in bank liquidity management, money markets, securities financing, dealer funding, and central bank monetary policy.

In this study note, you’ll learn:

• How repo transactions work
• How repo pricing and repo rates are calculated
• How margins and haircuts protect lenders
• What reverse repos are
• Why repos are used in money markets
• Benefits and risks of repo transactions
• Practical CFA Level I applications

How Does a Repo Transaction Work?

A repo transaction usually follows five basic steps:

Step	Transaction
1	Borrower sells securities to the lender
2	Lender provides cash to the borrower
3	Borrower agrees to repurchase the securities later
4	Repurchase occurs at a higher price
5	The difference between sale and repurchase price represents repo interest

Although the transaction is legally structured as a sale and repurchase, it functions economically as a collateralized short-term loan.

Why Do Repurchase Agreements Matter?

Repurchase agreements matter because they support liquidity across financial markets. Banks, dealers, hedge funds, institutional investors, and central banks use repos to borrow cash, invest excess funds, finance securities inventories, and manage short-term liquidity needs.

Repos are often considered safer than unsecured borrowing because the lender receives securities as collateral. If the borrower fails to repurchase the securities, the lender can sell the collateral to recover funds.

Repos are also important in central bank operations. Central banks may use repo transactions to inject liquidity into the banking system or reverse repos to absorb liquidity.

For CFA candidates, repos connect short-term funding, collateral management, interest rate markets, liquidity risk, and counterparty risk.

Features and Calculations

Repos may require collateral in excess of the cash exchanged, termed as initial margin.

$$ \text{Initial margin}=\frac{\text{Initial security price}}{\text{Initial purchase price}} $$

A loan that’s backed entirely by collateral has a 100% initial margin. If the margin is greater than this, it indicates that there’s even more collateral provided initially. You can think of this extra collateral as a “haircut” or reduction to the loan in comparison to the starting value of the collateral. The equation representing this concept is:

$$
\text{Haircut} =\frac{\left(\text{Initial Security Price} – \text{Purchase Price at the start}\right)}{\text{Initial Security Price}} $$

Repos adapt to fluctuations in collateral value by allowing those involved in the contract to either ask for more collateral or give back some of what they’ve already provided. This ensures that the security interest remains consistent with the originally agreed-upon margin terms. This fluctuating margin payment, known as the variation margin, measures the gap between the current required margin and the value of the security at a specific time, which is represented in the following equation:

$$ \begin{align*} \text{Variation margin} = & (\text{Initial margin} \times \text{Purchase price at time t}) \\ – & \text{Security Price at time t}. \end{align*} $$

Why Do Repos Use Haircuts and Margins?

Repos use haircuts and margins to protect lenders from losses if the collateral declines in value.

A haircut reduces the amount of cash lent relative to the market value of the collateral. For example, if securities worth $100 million are subject to a 2% haircut, the borrower may receive only $98 million in cash.

Initial margin sets the relationship between collateral value and the amount borrowed. Variation margin adjusts collateral during the life of the repo if market values change.

Haircuts are usually smaller for high-quality, liquid collateral such as Treasury securities. They are usually larger for lower-quality or less liquid collateral because the lender faces greater risk if the borrower defaults.

Daily mark-to-market adjustments help ensure that the collateral remains sufficient throughout the repo term.

Typical Repo Collateral

Collateral	Typical Risk
Treasury Bills	Very low
Government Bonds	Low
Agency Securities	Low
Investment-Grade Corporate Bonds	Moderate
Mortgage-Backed Securities	Higher

Uses of Repos

1. Financing Securities: Institutions that trade or hold securities, such as banks, often use the repo market to finance their security ownership. It enables them to manage their cash flow efficiently without selling the asset.
2. Secured Lending: From the perspective of the buyer in a repo transaction, it’s an opportunity to lend funds on a short-term basis with the added security of collateral, thus minimizing default risk.
3. Short Selling: Some entities utilize repos to borrow securities for short selling, a strategy where the borrower believes the asset price will decrease.

How Do Central Banks Use Repos?

Central banks use repos and reverse repos to manage liquidity in the financial system and support monetary policy implementation.

A central bank may use repos to inject liquidity by providing cash to financial institutions against eligible collateral. This can help stabilize funding markets and support short-term interest rate control.

A central bank may use reverse repos to absorb liquidity by taking in cash and providing securities as collateral. This can help keep short-term rates within the desired policy range.

Central bank repo operations are important because they connect money markets, collateral markets, bank reserves, and monetary policy.

Benefits of Repos

1. Liquidity: Repos provide immediate liquidity, making them invaluable for institutions requiring short-term funds.
2. Security: Repos are collateralized, meaning the risk of default is lower compared to unsecured loans.
3. Flexibility: With durations ranging from overnight to longer-term, repos can cater to diverse liquidity needs.
4. Central Bank Operations: Central banks use the repo market as a tool for implementing monetary policy, allowing them to manage liquidity in the banking system.

Factors Influencing Repo Rates

1. Money market interest rates: Repo rates align with short-term interest rates, and central banks utilize secured repo markets to influence unsecured central bank funds rates.
2. Collateral quality: Greater collateral risk leads to higher repo rates, with equity securities or emerging market bonds typically having higher rates compared to developed market government bonds.
3. Repo term: Repo rates tend to rise with maturity due to higher long-term rates in normal market conditions, increasing credit risk with longer terms.
4. Collateral uniqueness: Demand for specific securities inversely affects repo rates, with recently issued or on-the-run developed market sovereign bonds typically commanding lower rates.
5. Collateral delivery: Repo rates are higher when cash lending is undercollateralized or no collateral is provided to the funds lender.

What Determines the Repo Rate?

The repo rate is the interest rate implied by the difference between the initial sale price and the repurchase price.

Repo rates are influenced by several factors, including:

• General money market interest rates
• Central bank policy rates
• Term of the repo
• Quality and liquidity of the collateral
• Credit risk of the borrower
• Supply and demand for specific securities
• Market stress and funding conditions

Overnight repos usually have very short maturities and may closely reflect short-term money market rates. Term repos last longer and may include higher rates if lenders require more compensation for funding and collateral risk.

High-quality government securities usually support lower repo rates because they are liquid and have relatively low credit risk. Lower-quality or less liquid collateral usually requires a higher repo rate or a larger haircut.

What Risks Are Associated with Repos?

1. Default Risk: Despite being secured, there remains a risk of default. If a party fails to meet its obligations, the other party might suffer losses, especially if the collateral’s value has depreciated.
2. Collateral Risk: The quality, liquidity, and value of the collateral can fluctuate. If a party defaults, the other might find it challenging to liquidate the collateral at the expected value.
3. Margining risk: It’s crucial to ensure accurate and prompt valuation of collateral and the transfer of variation margin. This helps prevent collateral deficiencies if there’s a need to liquidate after a default. Moreover, unfavorable market situations might lead to significant shifts in collateral’s value, amplifying margin requirements and prompting more liquidations among traders.
4. Legal risk: This pertains to the enforceability of rights within a repurchase agreement.
5. Netting and settlement risk: This involves the capability of those involved in a repo contract to either offset the duties of a party that hasn’t defaulted and to claim either collateral or cash as a trade settlement.

Repos reduce credit risk through collateral, but they are not risk-free.

Important repo risks include:

Counterparty risk: The risk that one party fails to fulfill its obligation to repurchase or return securities.

Liquidity risk: The risk that collateral cannot be sold quickly without a significant price discount.

Settlement risk: The risk that cash or securities are not delivered as expected.

Market volatility: The risk that collateral values change sharply during the repo term.

Wrong-way risk: The risk that the borrower’s credit quality and collateral value deteriorate at the same time.

Operational risk: The risk of errors in documentation, settlement, collateral valuation, or margining.

These risks explain why repo transactions rely on collateral, haircuts, margin calls, and careful counterparty risk management.

Risk Management

Repo market players often involve a third party for risk management. Direct transactions between two entities are termed bilateral repos. On the other hand, triparty repos involve a third-party agent agreed upon by both main parties. The triparty agent, such as a custodian, oversees the transaction, including cash, securities, collateral valuation, and safekeeping. Triparty agents enable cost efficiencies, larger collateral pools, and access to multiple counterparties. Although the repo market is stable, it poses significant rollover and liquidity risks, especially during adverse conditions. Financial institutions must weigh the affordability of repo funding against the flexibility of pricier long-term financing methods. While repo transactions are collateralized, they’ve led to significant losses during crises due to over-reliance on repo financing by some firms.

Example: How a Repo Works

A bank owns $10 million in Treasury securities but needs overnight cash.

Instead of selling the securities permanently, it enters into a repo.

The bank:

• Receives cash today
• Uses Treasury securities as collateral
• Agrees to repurchase the securities tomorrow
• Pays repo interest through the higher repurchase price

This allows the bank to raise short-term liquidity while maintaining economic exposure to the securities.

Question #1

Assume that today (t=0) the current US ten-year Treasury note trades at a price equal to the bond’s face value of USD150,000,000. The security buyer takes delivery of the US Treasury note today and pays the security seller a purchase price based on an initial margin of 104%. The repo haircut is closest to:

1. 0.00%
2. 3.85%
3. 4.00%

Solution

The correct answer is B:

The face value of the US ten-year Treasury note = USD150,000,000.

Initial margin =104%

Now, the “Purchase Price” can be found using the formula:

$$ \begin{align*} { \text{Purchase Price} } & =\frac{{\text{Security price}}}{{ \text{Initial Margin} }} \\
{\text{Purchase Price} } &=\frac{ \text{USD } 150,000,000}{1.04}=\text{USD } 144,230,769.23 \end{align*} $$

Now, the repo haircut is defined as:

$$ {\text {Haircut} }=\left(\frac{\text{Initial Security Price} {-\text{Purchase Price} }}{\text{Initial Security Price}}\right)\times100\% $$

Inserting our values:

$$ {\text{Haircut} }=\left(\frac{{\text {USD } }150,000,000-{ \text{USD } }144,230,769.23}{{ \text{USD } }150,000,000}\right)\times100\%=3.85\% $$

Question #2

Which of the following best describes the primary use of a repurchase agreement (repo) in the context of financial institutions?

1. Hedging against exchange rate fluctuations.
2. Financing their security ownership.
3. Securing long-term funding for capital expenditure.

Solution

The correct answer is B:

Financial institutions often use the repo market to finance their security ownership, which enables them to manage their cash flow efficiently without selling the asset.

A is incorrect: Hedging against exchange rate fluctuations is not the primary use of repos.

C is incorrect: Repurchase agreements are primarily for short-term funding, not long-term capital expenditure.

Question #3

What are the inherent risks associated with repurchase agreements?

1. Inflation risk, currency risk, and equity risk.
2. Default risk, collateral risk, and legal risk.
3. Commodities risk, strategic risk, and liquidity risk.

Solution

The correct answer is B:

Repos come with risks such as default risk (if a party fails to meet its obligations), collateral risk (related to the quality, liquidity, and value of the collateral), and legal risk (related to the enforceability of rights within a repurchase agreement).

A is incorrect: Inflation risk, currency risk, and equity risk are more general market risks and not specifically inherent to repos.

C is incorrect: While liquidity risk is a concern for the repo market, commodities risk and strategic risk aren’t primary risks associated with repurchase agreements.

Glossary

Repurchase Agreement — A secured short-term financing transaction in which one party sells securities and agrees to repurchase them later.

Repo — Short form of repurchase agreement.

Reverse Repo — The same transaction viewed from the lender’s perspective, where cash is provided and securities are received as collateral.

Repo Rate — The interest rate implied by the difference between the sale price and repurchase price.

Initial Margin — The relationship between collateral value and the amount borrowed at the start of the transaction.

Haircut — The reduction in loan value relative to the collateral’s market value.

Variation Margin — Additional collateral or cash exchanged when collateral values change.

Collateral — Securities pledged to secure the repo transaction.

Counterparty Risk — The risk that the other party fails to meet its obligation.

Mark-to-Market — The process of updating collateral values based on current market prices.

Overnight Repo — A repo transaction that matures the next day.

Term Repo — A repo transaction with a maturity longer than overnight.

Open Repo — A repo transaction with no fixed maturity date.

Liquidity Risk — The risk that securities cannot be sold quickly without a significant price impact.

Frequently Asked Questions

What is a repurchase agreement?

A repurchase agreement is a secured short-term financing transaction in which one party sells securities and agrees to repurchase them later at a higher price.

How does a repo work?

In a repo, the borrower sells securities for cash and agrees to repurchase them later. The difference between the sale price and repurchase price represents interest.

What is the difference between a repo and a reverse repo?

A repo is viewed from the cash borrower’s perspective, while a reverse repo is viewed from the cash lender’s perspective. They are opposite sides of the same transaction.

What is a repo rate?

The repo rate is the borrowing cost implied by the difference between the initial sale price and the later repurchase price.

What is a repo haircut?

A repo haircut is the reduction in the cash lent relative to the market value of the collateral.

Why are repos considered secured loans?

Repos are considered secured because the cash lender receives securities as collateral.

What securities are used as repo collateral?

Common repo collateral includes Treasury bills, government bonds, agency securities, investment-grade corporate bonds, and mortgage-backed securities.

How do central banks use repos?

Central banks use repos to inject liquidity and reverse repos to absorb liquidity from the financial system.

What risks are associated with repos?

Repos involve counterparty risk, liquidity risk, settlement risk, market volatility, wrong-way risk, and operational risk.

Why are repos important in financial markets?

Repos are important because they support short-term funding, liquidity management, securities financing, and monetary policy operations.

Repurchase Agreement Summary

Concept	Description
Repo	Collateralized short-term borrowing
Reverse Repo	Collateralized short-term lending
Repo Rate	Interest charged on repo financing
Initial Margin	Collateral value relative to loan
Haircut	Reduction in loan value versus collateral
Variation Margin	Daily collateral adjustment
Main Users	Banks, dealers, institutional investors, central banks