What is Repo?
Repo (Repurchase Option) is a formal agreement between two counterparties where one party sells securities to another party with the explicit intention of buying back the securities at a later date. The Repo can be called a Sell-Buy transaction. The seller of the securities agrees to buy back the securities from the buyer at a predetermined time and rate. The rate at which the seller agrees to buy back the securities will include the interest rate charged by the buyer for agreeing to buy the securities from the seller.
The reason a seller wants to sell and buy back securities and paying interest on the transaction is that the seller requires funds. The seller of securities can be called as the Repo borrower as he receives funds for selling the securities. The buyer of the securities is the Repo lender as he pays for the securities purchased.
The Repo rate is the rate of interest charged by the buyer of the securities to the seller of securities.
A Repo transaction has two legs. The first leg is the sale of securities by the Repo borrower to the Repo lender. The second leg is the purchase of securities by the Repo borrower from the Repo lender.
Illustration 1 shows how a Repo transaction works.
How is interest calculated on the Repo transaction?
The Repo rate is the interest rate paid by the Repo Borrower to the Repo lender. How is the interest calculated and paid by the borrower to the lender. Example 1 shows how a Repo transaction takes place in the market.
Example 1. Repo transaction in the market
A Repo transaction is the actual sale of securities by the Repo borrower to the Repo lender. The securities sold could be government bonds, corporate bonds, treasury bills and other money market instruments. Let us take the example of a Repo borrower selling government bonds to the Repo lender. The Repo period is one day and the Repo rate is 7.50%.
The government bond sold by the Repo Borrower to the Repo Lender is the benchmark ten year government bond the 8.15% 2022 government bond. The first leg settlement date is 11th of March 2013 and the second leg settlement date is 12th of March 2013.
Details of 8.15% 2022 Government Bond
The 8.15% 2022 Government Bond matures on the 11th of June 2022 and pays semi annual interest on the 11th of June and 11th of December. The bond is trading at a price of Rs 101.93 that translates into a semi annual yield of 7.85%. The last interest payment date on the bond was 11th of December 2012 and the next interest payment date is the 11th of June 2013.
Table 2. gives the first leg cash inflow and second leg cash outflow of the Repo Borrower.
Table 2. Cash inflow and outflow of the Repo Borrower in a Repo transaction
The cash inflow to the Repo Borrower in the first leg is calculated by adding accrued interest to the price of the bond. The interest outgo for the Repo rate borrower in the second leg is calculated by the Repo interest rate on the cash inflow. The Repo borrower pays interest on the full sum of money received by him from the Repo lender.
The above example gives you the actual cash flows involved in a Repo transaction. Repo transactions take place between the RBI and banks, RBI and primary dealers, banks to banks, banks to other counterparties, primary dealers to primary dealers and primary dealers to other counterparties.
In the next tutorial we will look at the Repo market in India.