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2.7.3. Repurchase agreements

2.7.3.1. Introduction

A knowledgeable student will have noted that the above deal (the OTC FIRC) could have been executed by the insurer by way of the celebrated repurchase agreement (repo). The insurer could have bought the NCDs outright and sold them to some other holder of funds under repo for 100 days. Similarly the bank could have bought the NCDs outright, sold them under repo for 100 days and then sold them outright to the insurer.

In most international textbooks, the repo is not covered under derivative instruments, but is rather regarded as a money market instrument. We regard the repo as a derivative because it is derived from money or bond market instruments, and its value (i.e. the rate on it) is derived from another part of the money market (the price of money for the duration of the repo).

The repo may also be seen as a combination of a spot and a forward transaction, specifically a spot sale and a simultaneous forward purchase of the same instrument (from the point of view of the seller / maker). The buyer of the repo does a simultaneous spot purchase and forward sale.

The repo may also be regarded as a short-term loan secured by the assets sold to the lender. Another way of putting this is that the repo is similar to a collateralized loan in that the purchaser of the securities under repo is providing funds to the seller and its loan is backed by the securities for the period of the agreement; the lender receives a return based on the fixed price of the agreement when it is reversed.

The repo is discussed in much detail here because it is a versatile instrument and the market in this instrument is vast. The sections we cover here are:

• Definition

• Terminology

• Example

• Purpose of effecting repurchase agreements

• Participants in the repurchase agreement market

• Types of repurchase agreements

• Securities that underlie repurchase agreements

• Size of repurchase agreement market

• Mathematics of repurchase agreements

• Repos and the banking sector

• Listed repurchase agreements.

2.7.3.2. Definition

A repurchase agreement (repo) is a contractual transaction in terms of which an existing security is sold at its market value (or lower) at an agreed rate of interest, coupled with an agreement to repurchase the same security on a specified, or unspecified, date. This definition perhaps requires further elaboration.

Agreement

The transaction note confirming the sale of the security can contain a note stipulating the agreement to repurchase. Alternatively, two transaction notes can be issued, i.e. a sale note together with a purchase note dated for the agreed repurchase date. It is market practice that underlying all repurchase agreements is the TBMA / ISMA Global Master Repurchase Agreement, (GMRA), i.e. an internationally recognized repo contract.

Existing security

The maker of the repo sells a security already in issue to the buyer of the agreement.

Market value

The security is sold at its market value (and sometimes at better, i.e. lower, than market value), in order to protect the buyer of the repo against default of the maker. If the seller fails to repurchase the security at termination of the repo, the holder acquires title to it and has the right to sell it in the market. For example, if the value of the securities sold is LCC9 500 000, the repo is done at a value of LCC9 450 000, and the interest factor for the period of the repo is LCC35 000 (total = LCC9 485 000), the buyer is protected should the maker default.

Agreed rate of interest

The agreed rate for the term of the agreement is the interest rate payable on the repo by the seller for the relevant period. This applies in the case where the maturity date of the agreement is specified. A small number of repos are "open repos", i.e. both the buyer and the seller have the right to terminate the agreement at any time. The rate payable on these open repos is a rate agreed between the two parties to the deal; the rate may be benchmarked or it may be agreed daily.

Specified maturity date

The specified maturity date is the date when the agreement is terminated. The buyer sells the security / securities underlying the repo back to the maker for the original consideration plus the amount of the interest agreed.

Unspecified maturity date

In the case of an agreement where the maturity date is not specified (the open repo), the termination price (original consideration plus interest) cannot be agreed at the outset of the agreement. The rate at which interest is calculated can be fixed or floating, but is usually the latter. In the case of a floating rate, as noted, the rate would be an agreed differential below or above a benchmark rate.

 
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