Characteristics of Repurchase Agreements

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A repurchase agreement involves a short-term transaction that allows the borrower to obtain credit and fulfill their short-term needs. Repurchase agreements are popular amongst banks and financial institutions as they often require short-term capital to meet their operating requirements. A bank with surplus cash can lend money to another bank with a deficit in cash. This helps banks secure a yield with minimal risk. The transaction involves the sale of a security or portfolio of securities with a promise to repurchase the security at a future date.

Guaranteed Principal

In his book "Strategic Facilities Planning: Capital Budgeting and Debt Administration," Alan Walter Steiss states that "Little risk is involved in such agreements because the principal is guaranteed and the return is fixed." The repurchase agreement provides collateral in the form of securities to facilitate the transaction, thus reducing the risk involved. The securities are sold with a promise to repurchase, making the transaction technically a debt instrument instead of a sale.

Specified Price

The repurchase price of the securities is predetermined in the agreement that is signed between the borrower and lender. The repurchase price has to be higher than the current price as it must incorporate a yield for the lender. Therefore, the repurchase price is not based on the expected future price of the securities but rather on the market interest rates prevailing at that particular time.

Short Duration

Frank Fabozzi, in his book "Securities Lending and Repurchase Agreements," states that "A repurchase agreement is normally of a short duration and ranges between one to 21 days." However, this agreement can be rolled over if the borrower needs to extend the term of the agreement. A roll over requires the formation of a new contract between the two parties. Banking institutions tend to have short-term requirements that usually last for a single day; these agreements are not rolled over very often.

Minimum Amount

The minimum amount that can be borrowed using a repurchase agreement is $100,000, with increments of $5,000 above the minimum permitted. This minimum amount can be negotiated between the parties in unique circumstances.

Fixed or Open Repurchase

Steiss also notes that a repurchase agreement can be fixed or open as defined by the contract. A fixed agreement has a fixed date of maturity, and if terminated early the lender has the option of charging the borrower a predefined penalty. An open repurchase agreement can be terminated any time, from its inception to maturity, without a penalty. The yield in both agreements is fixed but the repurchase price depends on the amount of time the capital is utilized by the borrower.

References

  • "Securities Finance: Securities Lending and Repurchase Agreements"; Frank Fabozzi and Steven Mann; 2005
  • “Cash Management: Products and Strategies”; Frank Fabozzi; 2000

About the Author

Kevin Sandler started his writing career as an academic researcher in 2005, and has since than been involved in writing for various magazines and academic specialists including Academic Knowledge, Scholastic Experts and eHow, among others. His specialities include personal finance, investments, business and project management. He has a Master of Science in finance from Tulane University, and is actively involved in the finance profession.

Photo Credits

  • fastening of the finance image by Yuriy Poznukhov from Fotolia.com