These are purchase and repurchase agreements used by money market participants to finance their loans. Such transaction when viewed from the point of view of the supplier of funds, is called Reverse Repo. Similarly, when viewed from the point of view of seller of securities (the party acquiring funds), it’s called 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. However, there will be several legal difficulties in doing so. As Mr. B doesn’t possess bills or invoices stating that such watch is sold to him, he cannot sell easily to third party without undergoing a legal trouble.
However, to overcome such difficulty, let’s assume Mr. A and Mr. B enter into loan contract in different way yet reflecting same transactions as above. This time, Mr. A sells his watch for ₹50,000 to Mr. B. Now Mr. B receives invoice for that transaction. They also enter simultaneous forward contract wherein Mr. A promises to purchase the watch after 2 months at ₹50,000 plus interest portion say ₹51,000 (for total). This is basically nothing but a pure sale and repurchase agreement allowing seller to take loan from selling his assets with lending party and repurchasing those pledged assets at future date on repayment of loan.
This way of financing loan from money market serves both lenders and borrowers as borrowers get the fund whenever required easily. Lender gets security which he can liquidate at any time by selling it to third party as he possesses ownership. Borrower on due date will purchase such securities back from lender or third party at the price agreed and thus repay his loan.
