Understanding a Repurchase Agreement

A repurchase agreement or "repo" as it is often called is a transaction in which an individual can use a financial security as the collateral for a loan. With this type of transaction, a financial institution will buy the financial security from the individual and the individual will then purchase it back at a predetermined time and price. Here are the basics of the repurchase agreement and how it works.

Secured Loan

The repurchase agreement is a type of secured loan much like a mortgage or an auto loan. The unique thing about this type of loan is that the collateral for it is some type of financial security. If the borrower does not make timely payments to the lender, the lender is then free to sell the financial security in order to get back the money that was loaned. This helps limit the amount of risk for the lender and it keeps the borrower accountable for the payments. When this type of loan is initiated, the ownership rights of the securities are passed onto the lender from the borrower. This is a unique feature that is not present in other types of secured loans. With other secured loans, the property is still in the name of the borrower but a lien is placed against it by the lender.

Securities

With this type of loan, nearly any type of security could be used as collateral. In most cases, lenders will preferred that the collateral be something that is highly liquid. This way, if the loan goes into default, it will not be difficult for the lender to sell the securities and get their money back. Some examples of securities that can be used for this type of loan are shares of stock, corporate bonds, government bonds and treasury securities. 

Types of Repurchase Agreements

There are several types of repurchase agreements that you could choose to get involved with. For example, one type of repurchase agreement is referred to as the due bill repo. With this type of repo, the collateral is not given to the lender, but it is kept in a cash account. 

Another type of repurchase agreement is called the tri-party repo. With this type of transaction, a third-party is used to act as the intermediary between the two parties in the transaction. The third-party keeps the collateral and then distribute it to the appropriate party when the time is right. This provides a little bit of extra safety for both of the parties involved.

An equity repo is another type of repurchase agreement that is commonly used. This type of repurchase agreement means that the loan is secured by equities or stocks instead of a safer type of collateral. The majority of repurchase agreements are secured with government bonds or corporate bonds. Equity repos are a little bit more risky for the lender because the value of the stock can plummet very quickly and the collateral would be worth nothing.

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