A repurchase agreement, also known as a repo, is a financial instrument used by banks and other financial institutions to obtain short-term funding. In this agreement, one party sells a security to another party with an agreement to repurchase the security at a later date and at a predetermined price.
Let`s take an example to understand how a repurchase agreement works. Suppose a bank needs funding for a short period, say ten days. The bank can approach another financial institution to enter into a repurchase agreement. In this agreement, the bank will sell a security, say a government bond, to the financial institution for a price, say $100. The financial institution will pay the bank $100, and the bank will use this money for its short-term funding needs.
The agreement will also specify the repurchase price and the repurchase date. Suppose the repurchase price is $101, and the repurchase date is ten days from the sale date. On the repurchase date, the bank will repurchase the government bond from the financial institution for $101, which includes the original amount of $100 plus one dollar as interest. The financial institution will return the government bond to the bank, and the repurchase agreement will come to an end.
In this example, the repurchase agreement has helped the bank to obtain short-term funding without selling its government bond permanently. The bank can reuse the government bond and continue earning interest on it. The financial institution has also earned a profit of one dollar as interest for ten days.
Repurchase agreements are popular among banks and financial institutions as they are a safe and reliable way of obtaining short-term funding. The agreements are also used by central banks to inject liquidity into the financial system during times of stress. Repurchase agreements are an essential tool in the financial world and play a crucial role in maintaining the smooth functioning of the financial system.