Examples of Repo and Reverse Repo

Repo

Consider the scenario wherein a dealer thinks a particular security’s price is about to rise but he does not have the cash to buy that security, then he can borrow the cash from the repo market(say from a bank) in exchange for lending the security. The dealer is said to be doing repo in this case. Here the securities will be transferred to the account of the lending Bank. These securities will be repurchased by the dealer at the end of the term. At the end of the term if the price of the security is increased then he can sell the security in the market to convert into a cash profit.

Carry

Carry refers to the profit or loss that made out of a repo. For a repo transaction, a security’s carry is the Profit/Loss, exclusive of capital gain, earned by the security and financing it with repo. Other words, carry is the difference between the coupon interest earned and the repo interest paid.

Carry can either be positive, negative, or zero.

Positive carry – When income from the asset being financed through a repo exceeds the cost of financing (i.e., repo rate plus expenses).

Negative carry - income from the asset being financed through a repo is less than the cost of financing.

Zero carry - income from the asset being financed through a repo is equal to the cost of financing.

Reverse Repo

A bank funds investors of stock market who feels that the current situation is suitable for investment but don’t have the cash in hand. In this case the bank is said to be doing reverse repo. Actaully in these transactions there are two parties one is doing repo and the other one is doing reverse repo. But the transaction is called repo/reverse repo based on the initiator of the first leg.

In the above example the shares are transferred to bank’s account. Usually banks lend only 70% (or less than 70%) of the funds required to avoid default risks. These are again transferred back to the investors. They are not popular in India.

July 19, 2008 | Filed Under Bonds | 1 Comment

Controlling Liquidity with Repo Rate and Reverse Repo Rate

Reserve bank controls repo rates and reverse repo rates as a measure of controlling liquidity and inflation. For commercial banks the major source of short term funding is Reserve Bank. Banks go short of money when there is a high demand for loans and the cash in hand at the banks is low. If RBI feels that the liquidity in the system is high and wants to make money more expensive it increases repo rate (The rate at which it lends to banks). Similarly if RBI feels there is a liquidity crunch in the market it reduces repo rate and hence the cost of money. Read more

July 19, 2008 | Filed Under Bonds | Leave a Comment

What is Repo Rate, Reverse Repo Rate ?

A repo or repurchase Agreement is an instrument of money market. Usually reserve bank (federal bank in U.S) and commercial banks involve in repo transactions but not restricted to these two. Individuals, banks, financial institutes can also participate in repurchase agreement.

Repo is a collateralized lending i.e. the banks which borrow money from Reserve Bank to meet short term needs have to sell securities, usually bonds to Reserve Bank with an agreement to repurchase the same at a predetermined rate and date. In this way for the lender of the cash (usually Reserve Bank) the securities sold by the borrower are the collateral against default risk and for the borrower of cash (usually commercial banks) cash received from the lender is the collateral. Read more