Characteristics of Repurchase Agreements

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.

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.

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.

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.

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.

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.