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Repurchase agreement
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==Structure== {{More citations needed|section|date=July 2021}} [[File:Repo transaction components.png|thumb|right|400px|Repurchase agreement or "Repo" transaction components. In step one, the investor provides $80 cash and receives $100 in collateral, typically bonds. In step two, the borrower buys back the collateral, paying the investor their initial cash plus an interest amount. The "repo rate" is the interest rate received by the investor, in this case (88β80)/80 = 10%, while the "Haircut" is a ratio of the cash loan to collateral (100β80)/100 = 20%.<ref name = "Gorton_2009"/>]] ===Repo facility=== In a repo, the investor/lender provides cash to a borrower, with the loan secured by the collateral of the borrower, typically bonds. In the event the borrower defaults, the investor/lender gets the collateral. Investors are typically financial entities such as money market mutual funds, while borrowers are non-depository financial institutions such as investment banks and hedge funds. The investor/lender charges interest (the ''repo rate''), which together with the principal is repaid on repurchase of the security as agreed. A repo is economically similar to a [[secured loan]], with the buyer (effectively the lender or investor) receiving securities for collateral to protect himself against default by the seller. The party who initially sells the securities is effectively the borrower. Many types of institutional investors engage in repo transactions, including mutual funds and hedge funds.<ref>Lemke, Lins, Hoenig & Rube, ''Hedge Funds and Other Private Funds: Regulation and Compliance,'' Β§6:38 (Thomson West, 2016 ed.)</ref> Although the transaction is similar to a loan, and its economic effect is similar to a loan, the terminology differs from that applying to loans: the seller legally repurchases the securities from the buyer at the end of the loan term. However, a key aspect of repos is that they are legally recognised as a single transaction (important in the event of counterparty insolvency) and not as a disposal and a repurchase for tax purposes. By structuring the transaction as a sale, a repo provides significant protections to lenders from the normal operation of U.S. bankruptcy laws, such as the automatic stay and avoidance provisions. ===Collateral=== Almost any security may be employed in a repo, though highly liquid securities are preferred as they are more easily disposed of in the event of a default and, more importantly, they can be easily obtained in the open market if the buyer has created a short position in the repo security by a reverse repo and market sale; by the same token, non liquid securities are discouraged. Treasury or Government bills, corporate and Treasury/Government bonds, and stocks may all be used as "collateral" in a repo transaction. Unlike a secured loan, however, legal title to the securities passes from the seller to the buyer. [[Coupon (bond)|Coupons]] (interest payable to the owner of the securities) falling due while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller. This might seem counter-intuitive, as the legal ownership of the collateral rests with the buyer during the repo agreement. The agreement might instead provide that the buyer receives the coupon, with the cash payable on repurchase being adjusted to compensate, though this is more typical of sell/buybacks. ===Overcollateralization (haircut)=== Further, the investor/lender may demand collateral of greater value than the amount that they lend. This difference is the "haircut." These concepts are illustrated in the diagram and in the equations section. When investors perceive greater risks, they may charge higher repo rates and demand greater haircuts. ===Reverse repo facility=== Whereas a repo facility is a security-buying party acting as a [[lender]] of cash to security sellers who effectively [[borrower|borrow]] cash at interest (the ''repo rate''), with the security they sell serving as [[Collateral (finance)|collateral]], a reverse repo facility is a security-selling party allowing buyers with cash to effectively lend it to the facility at interest with the security they purchase serving as collateral. An example is a bank with cash deposits who loans it to a reverse repo facility to earn interest on it and contribute to their own collateral requirements (as deposit banks) with the collateral they obtain in the transaction.<ref name="RRP">{{cite web | last = Chen | first = James | title = Reverse Repurchase Agreement | work = STOCK TRADING STOCK TRADING STRATEGY & EDUCATION | publisher = [[Investopedia]] | date = 28 December 2020 | url = https://www.investopedia.com/terms/r/reverserepurchaseagreement.asp | accessdate = 16 March 2021 }}</ref> ===Tri-party repo=== In a ''tri-party repo'', a third party facilitates elements of the transaction, typically custody, escrow, monitoring, and other services. <ref name = "Gorton_2009"/> === Structure and other terminology === The following table summarizes the terminology: {| class="wikitable" |- ! ! Repo ! Reverse repo |- ! Participant | Borrower<br />Seller<br />Cash receiver | Lender<br />Buyer<br />Cash provider |- ! Near leg | Sells securities | Buys securities |- ! Far leg | Buys securities | Sells securities |}
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