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.
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.
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