These are purchase and repurchase agreements. It is often used by money market participants to finance their loans. Such transaction when viewed from supplier of funds, is Reverse Repo. Likewise, to the party acquiring the funds, it is Repo.
To understand better, let’s take an example of traditional lending activity.
Mr. A borrowed ₹50,000 from Mr. B for 2 months @ 12% p.a. interest, by giving his golden watch as security. Here, if Mr. A doesn’t return the money in 2 months, Mr. B can sell his watch. But, there will be several legal difficulties in doing so.
Mr. B doesn’t have legal bills/invoices of the golden watch. Also, Mr. A is unlikely to give the legal bills to Mr. B. Or, even if he gives, it would be in the name of Mr. A.
Now, Mr. B will have trouble in selling the golden watch to recover his loaned amount. If Mr. A doesn’t co-operate, he will have to undergo a legal trouble.
To overcome such difficulty, let’s assume Mr. A and Mr. B enter into loan contract in a different way. The contract reflect the same transactions as above. But, this time, Mr. A sells his watch for ₹50,000 to Mr. B. Now Mr. B receives invoice for that transaction. They also make a forward contract. Mr. A promises to buy the watch after 2 months at ₹50,000 plus interest part say ₹51,000 (for total).
This is nothing but a pure sale and repurchase agreement. But it allows seller to take loan from selling his assets with lending party. In return he promises to buyback such assets at future date on repayment of loan. This promise to buyback is in written legal contract.
This way of financing loan from money market serves both lenders and borrowers. Borrowers get the fund whenever required. Lender gets security which he can liquidate at any time. He poses ownership and can sell to third party to recover his funds.
Borrower on due date will buy such securities back from lender. If lender sold it to third party, he can buy it from third party at the price agreed and thus repay his loan.
Leave a Reply