Repo Rate

In this article, Shruti CHAND (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2022) elaborates on the concept of repo rate.

This read will help you get started with understanding repo rate and its significance.

What is Repo?

Repurchase rate is the rate at which the financial institutions in a country borrow and lend assets amongst themselves for a short-term. In the interbank market, the underlying security is sold by a bank to another in exchange of buying it the next day at a higher price on the following day usually. This exchange of the asset is facilitated by a contract known as “Repurchase agreement at a rate” or more commonly referred to “Repo”.

This agreement is similar to a loan agreement where the borrower of the loan pledges collateral with the lender for the time it borrows money and claims it back when the loan agreement is fulfilled. The underlying asset is usually a money market instrument such as Treasury bills and Treasury bonds. The main criteria to qualify as a collateral is that it should be liquid so that it can be sold in the open market if required.

Let us understand how a repurchase agreement works in detail:

The party of the contract who lends money in exchange of interests is known as the “repo seller”.

The borrower of the loan is known as the “repo buyer”.

The rate of the loan at which the lending is facilitated is known as the “repo rate”.

The collateral allows the lender to be protected against counter-party risk of the borrower. The value of the collateral is always higher than the amount lent to provide protection against market risk associated with collateral value. This additional amount is known as “haircut”.

Example

Let us illustrate this concept with an example:

Let us say Bank A (the borrower) is in dire need of liquid cash to facilitate an important transaction. In this scenario, it will turn to the Bank B (the lender) and request an amount of $100 m in cash.

Both banks decide to sign a repurchase agreement to facilitate this request. Bank B agrees to lend $100 m to Bank A and in return, Bank A agrees to pledge to Bank B Treasury bonds of a value higher than the value lent. This additional amount is known as ‘haircut’ as mentioned above. Let us assume in this case the haircut is $20 m, then the value of collateral that Bank A will keep for Bank B is equal to $120 m.

On day one, a repurchase agreement is signed between both banks. Bank A facilitates the agreement by holding the asset collateral with itself and Bank B lends cash to Bank A for its operations.

On day two, Bank A repays to Bank B the borrowed amount of $100 m and interests computed with the repo rate over one day. Let us assume the repo rate is equal to 5%. In this case, Bank A will pay $13,888 of interests to Bank B on day two and Bank B will free the collateral to Bank A.

Now that you understand a repo transaction, what is important also is to understand that a repo is one of the very important sources of funding for financial institutions in an economy. Central banks in every country use repurchase agreements to maintain liquidity level in the economy.

For example, the European Central Bank (ECB) sets three rates to keep the prices stable in the Euro zone. One of these rates is known as Refinancing option or Repurchasing option, which is an agreement to repurchase the collateral that the banks keep with the ECB of the country to borrow money for a very short period of time. Banks keep their Treasury bills or eligible securities with the Central Bank in exchange of money, they buy it later at a fixed price. ECB sets this rate every six weeks. This is how the policy makers for the Euro zone control the inflation level within the economy. On the other hand, opposite measures will be taken when the Central Bank needs to pump money in the economy.

Final Words

Repo rates are crucial to every economy and it differs based on various factors and is taken in control by policy makers whenever needed. As a student curious about Finance, learning about Repo Rate will go a long way in the future to understand better how liquidity and prices in the economy is maintained.

Relevance to the SimTrade certificate

This post deals with Repo Rate and how it is managed in the EU zone context.

About theory

• By taking the SimTrade course , you will learn more about the markets. It’s important to remember that lending is a crucial part for investing.

About practice

• By launching the series of Market maker simulations, you can extend your learning about financial markets and trading approaches.

About the author

Article written in August 2021 by Shruti CHAND (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2022).