What is a forward repurchase agreement?
Under a forward repurchase agreement (term repo), a bank agrees to buy securities of Merchant then sell them back to the dealer shortly after at a pre-specified price. The difference between the buy and sell prices represents the implied interest paid for the deal.
Forward repurchase agreements are used as a short-term financing solution or a cash investment alternative with a fixed term ranging from overnight to a few weeks to several months.
Key points to remember
- Forward repurchase agreements are used by banks (i.e. lenders) to buy securities and then resell them later at an agreed price.
- The borrower pays back the money and interest at the repo rate at the end of the term.
- These repurchase agreements, which can be overnight or last for a few weeks or months, are used to raise short-term capital.
How a Forward Repurchase Agreement Works
The repurchase market, or repo, is where fixed income securities are bought and sold. Borrowers and lenders conclude repurchase agreements where cash is exchanged for debt issues to raise short-term capital.
A repurchase agreement is a sale of securities for cash with a commitment to repurchase the securities at a future date for a predetermined price – this is the perspective of the borrowing party. A lender, such as a bank, will enter into a repurchase agreement to purchase the fixed income securities from a borrowing counterparty, such as a broker, with the promise to resell the securities within a short period of time. At the end of the term of the agreement, the borrower pays the money back plus interest at a repo rate to the lender and takes back the securities.
A repo can be either overnight or term. An overnight repurchase agreement is an agreement in which the term of the loan is one day. Forward repurchase agreements, on the other hand, can last for up to a year, with the majority of forward repos having terms of three months or less. However, it is not uncommon to see term repos with a maturity as long as two years.
Benefits of a Forward Repurchase Agreement
Banks and other thrift institutions that hold excess liquidity quite often use these instruments because they have shorter maturities than certificates of deposit (CD). Forward repurchase agreements also tend to pay higher interest than overnight repurchase agreements because they carry a higher interest rate risk since their maturity is longer than one day. In addition, collateral risk is higher for term repos than for overnight repos because the value of assets used as collateral is more likely to decline over a longer period of time.
Central banks and banks enter into forward repurchase agreements to allow banks to strengthen their Capital reserves. Later, the central bank would resell the treasury bills or government pocketbook to commercial bank.
By buying these securities, the central bank is helping to boost supply of money in the economy, thereby encouraging spending and reducing the cost of borrowing. When the central bank wants the growth of the economy to contract, it first sells government securities and then buys them back on an agreed date. In this case, the agreement is qualified as reverse repurchase agreement.
Requirements for a Forward Repurchase Agreement
The financial institution that buys the securities cannot resell them to another party, unless the seller defaults on its obligation to repurchase the securities. The security involved in the transaction acts as collateral for the buyer until the seller can reimburse the buyer. Indeed, the sale of a security is not considered as an actual sale, but as a secured loan which is secured by an asset.
The pension rate is the cost of repurchasing the securities from the seller or lender. The rate is a simple interest rate that uses a real/360 calendar and represents the cost of borrowing in the repo market. For example, a seller or a borrower may have to pay a 10% higher price at the time of redemption.