What it means
In an SRA, a borrower needs cash and owns securities, such as government bonds. The borrower sells the securities to a lender today and promises to repurchase them later at an agreed, slightly higher price.
The difference between the sale price and the repurchase price is the interest on the loan. It is usually expressed as an annual rate, called the repo rate, and the loan is typically very short, from overnight to a few weeks.
Although legally a sale, the arrangement works like a secured loan. The lender holds the securities as protection, and if the borrower fails to repurchase them the lender can keep or sell them, which is why the rates are generally lower than for unsecured borrowing.
The securities used are usually high quality, such as government bonds, which reinforces the safety of the loan. Banks, brokers and funds use SRAs to raise cash cheaply and to fund their trading positions.
Central banks also use them to add or remove cash from the financial system, which makes the repo market one of the most important parts of short-term money markets. Problems in this market can spread quickly through the rest of the financial system.
Lenders usually protect themselves with a haircut, which means lending less than the market value of the securities. If a bond is worth $10,000,000 and the haircut is 2%, the lender advances $9,800,000, leaving a cushion if the bond's price falls.
The mirror image of the repo is the reverse repo, which is the same transaction seen from the cash lender's side. The words repo and reverse repo describe the same deal depending on which party you are, so a bank can be doing a repo with one counterparty and a reverse repo with another on the same day.
In practice
Real-world examples.
Example
A bank needs cash for a week to meet its obligations. It sells government bonds under an SRA and repurchases them seven days later, paying a small amount of interest. The cost is far lower than the rate on an unsecured loan for the same period.
Example
A company with spare cash lends $5,000,000 to a bank overnight through a reverse repo. It earns interest and holds bonds as security until the bank repays the next day. The company treats the deal as a safe place to hold surplus cash for one night.
Example
A central bank conducts an SRA with commercial banks to increase the cash available in the system. The banks receive cash today and buy back their securities at a later date. When the central bank wants to reduce cash, it does the opposite.
Formula
Calculation
Repurchase price = sale price x (1 + repo rate x days / 360)
A bank sells securities for $10,000,000 under an SRA with a repo rate of 5% for 36 days, using a 360-day year. The interest is 10,000,000 x 0.05 x 36 / 360 = 10,000,000 x 0.05 x 0.1 = $50,000. The repurchase price is 10,000,000 + 50,000 = $10,050,000.Case study
Seen in the real world.
Stonebridge Bank is an illustrative, fictional lender that held $50,000,000 of government bonds. It needed $20,000,000 of cash for two weeks to fund a large loan before a customer repaid it.
Rather than selling the bonds permanently, Stonebridge arranged an SRA with a haircut of 2%, selling $20,408,163 of bonds to receive $20,000,000 of cash. The repo rate was 4.5% for 14 days, so the interest was 20,000,000 x 0.045 x 14 / 360 = $35,000.
Stonebridge repurchased the bonds on time and kept its holdings intact. The illustrative lesson is that an SRA cost only $35,000 for two weeks, much less than the cost and market risk of selling and rebuying the bonds. The treasurer noted that a permanent sale would also have triggered transaction costs and possibly a taxable gain.
Watch out
Common mistakes.
- Treating an SRA as a pure sale, when the seller has agreed to repurchase and still carries the price risk of the securities.
- Ignoring the haircut, which means the cash received is lower than the market value of the securities.
- Forgetting that the securities must be returned on the repurchase date, so the borrower needs the cash and the right to settle on time. A failure to settle can lead to penalties or the loss of the securities.
Questions
People also ask.
Is an SRA the same as a repo?
Yes, sale and repurchase agreement is the formal name and repo is the everyday market term for the same transaction.
Who bears the risk if the securities lose value?
The seller does, since it will repurchase them at the agreed price, and the lender uses the haircut and margin calls to protect itself. If the securities fall in price, the borrower may be asked to add cash or more securities.
Why are repo rates lower than unsecured loan rates?
The lender holds high-quality securities as collateral, so its risk of loss is smaller than on a loan with no security. The tenor, or length, of the deal also matters, as longer repos usually carry a slightly higher rate.
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