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Sunday, October 4, 2015

What Is Repo and Reverse Repo?

Repurchase Options or Repos are a mechanism through which the Reserve Bank Of India infuses liquidity into the banking system by lending money to the banking institutions. Repos are backed by a collateral - which generally takes the form of approved debt securities.

A Reverse repo is similar to a repo transaction, however, in this case the borrower is the Reserve Bank and the lender can be any of the banking institutions. A reverse repo can be used by the central bank to withdraw liquidity from the banking system. 



How does a Repo transaction work?


Under a Repo transaction, a bank will sell an approved security to the RBI in exchange of funds with an agreement to 'repurchase' the same at a predetermined date and price. Thus selling bank has an "option" to "repurchase" the security on a predetermined date and rate and hence the name "Repurchase Option". The opposite happens in case of a reverse repo transaction.

The difference between the price at which the security is sold to the Reserve Bank and the 're-purchase' price translates into the Repo rate.  


Example:

Bank A is in a temporary shortage of funds and enters into a Repo transaction with the RBI for an approved security. It sells an approved security A to the RBI for Rs. 99.5 with an agreement to buy it back 7 days hence at Rs. 100. 

The difference between the selling price and the buy-back price is Re. 0.50 

The repo rate can be computed as follows:

(Re 0.50 / Rs. 99.5) * 100 * 365/7
= 26.20 %

Note that we have used the clean spot price and the clean forward price of the approved security for the purpose of computing the Repo rate. 

Repo transactions are also known as ready-forward transactions.

Recommended Read: Concept of Clean and Dirty Price


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