Structure of Repurchase and Reverse Repurchase Agreements

Companies use repurchase agreements to raise short-term cash for operations. Suppose Investment Bank, Inc. is structuring new issues of bonds and working on mergers and acquisitions. It actually does not have a lot of cash on hand to fund day-to-day operations. Investment Bank, Inc. spends a lot of time working on these deals until cash flows come in at a much later date. On the other hand, National Bank Co. is taking in lots of deposits and has cash on hand to loan. Investment Bank, Inc. requests an overnight loan and National Bank asks for collateral. In this case, what kind of collateral do you think Investment Bank might use?

Not quite. For overnight loans in the repo markets, this is not the easiest security to liquidate in case of default. It is unlikely this is the collateral that National Bank Co. will accept. Instead, National Bank Co. is most likely willing to buy securities overnight that are liquid, such as treasuries, in case of default. Banks want to deal with creditworthy companies to limit the risk of default.

Correct. National Bank Co. is most likely willing to buy securities overnight that are liquid, such as treasuries, in case of default. Banks want to deal with creditworthy companies to limit the risk of default.

The repo rate, or interest rate, on the loan is negotiable and reflects the risk associated with the underlying securities used as collateral and the company itself. Factors such as risk associated with the collateral, the term of the agreement, the demand for the collateral in general, and interest rates of alternative financing all play a role in the repo rate that is negotiated. What do you think the repo rate will be on this repurchase agreement?

Not quite. The interest rate should be lower than that of, for example, commercial paper. Commercial paper is strictly bought and sold on the credit of the underlying issuer. No collateral is used. Since actual collateral is used in the transaction, it is less risky. Further, the collateral is the most creditworthy and liquid bond in the market. The term also is a factor. Since the loan is for one night, it is highly unlikely that Investment Bank, Inc. will undergo financial distress or bankruptcy in one day.

Correct. The interest rate should be lower than that of, for example, commercial paper. Commercial paper is strictly bought and sold on the credit of the underlying issuer. No collateral is used. Since actual collateral is used in the transaction, it is less risky. Further, the collateral is the most creditworthy and liquid bond in the market. The term also is a factor. Since the loan is for one night, it is highly unlikely that Investment Bank, Inc. will undergo financial distress or bankruptcy in one day.

To sum up: [[summary]]

Physical assets such as property and land

Securities such as government bonds and treasuries

Very high compared to other short-term financing options due to risky business that investment banks engage in

Somewhat lower than alternative short-term financing due to the credit quality and liquidity of the treasuries

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