Repurchase Agreements

A repurchase agreement (REPO) is a contract under which one of the parts sells securities to the other part, and simultaneously carries out an agreement to buy them again in the future at a previously agreed price. The US Government securities are the most commonly used securities.

The margin of time used to keep them safe is tailor-made according to one’s needs in transactions, but the larger part of the repurchase agreements are agreed upon only for a certain time.

The difference between the sales price and the repurchase price of a REPO is in the interests. Interests are taxed at the Federal State and local levels of government.

There are no regular published REPO rates because they are determined through direct negotiation between buyers and sellers. However, the rates of repurchase agreements are nearly related with the Treasury bills and federal fund rates. The rates of REPOs can be lower than the federal funds rate because of the safety provided by the securities involved in the repurchase agreement. This does not mean that the repurchase agreement lack risks. In 1982 the brokerage company Drysdale Securities, embezzled almost $4 million in repurchase agreements.

A REPO is a very safe loan, but even yet investors must take into account the following:

• The ability of the borrower to repay the loan.
• Not paying above the securities face value because if the seller is negligent you will lose money.

Then, would an investor or an institution want to buy a repurchase agreement instead of buying securities?

• The first advantage relies on that a REPOs maturity can be done on the required period of time by short-term money.
• A REPO almost eliminates loss risks due to market fluctuations of securities used in the transaction. Of course sellers could sell their securities when cash is needed, but there is a disadvantage to this action. If the price of securities drop below their purchasing price, there is a loss in capital.

The REPO buyer avoids this risk and is protected from these market fluctuations over securities. Those that participate in repurchase agreements are the securities dealers, corporations, and financial institutions. Unfortunately due to the great amount of transactions ($1 million or more) many individual investors do not invest directly in this type of money market securities.

The money-market securities just discussed offer investors the opportunity that their short-term liquid funds earn a return instead of leaving their money still and without earning any interests or earning very low interests in a bank account.

The warning would be that the short-term money-market securities in the long-term would provide enough defenses against inflation.