What is a repurchase agreement (Repo)?
A repo transaction involves two parties, the buyer and the seller. There are two exchanges that occur. One is at the start of the trade, the other is at maturity. At the start, the seller delivers collateral, normally bonds, to the buyer. In return the buyer simultaneously pays cash to the seller. That amount is equal to the market value of the collateral, this includes any accrued interest, (see diagram 1). On the maturity date the buyer returns the collateral to the seller. Simultaneously the seller repays the original cash amount to the buyer plus a sum of interest for being able to use the cash. The interest rate that is used is called the repo rate. The repo rate is normally calculated on a money market basis, actual/360, (see diagram 2). When dealers enter into a repo trade they agree the terms of the deal. These include the collateral involved, the maturity of the trade, (normally these trades are short term from 1 day to 3 months in maturity), the cash amount and the repo rate.
