Reverse Repo Rate
Fill in your details: What is the effect of repo and reverse repo rates on stock markets? If RBI cuts Repo rates in its next monetary policy review which is scheduled on 2 nd December then it means the cost of short-term credit can come down. So my friend still lends me the cash but now demands a higher interest to compensate for the higher risk as he has no collateral with him! What is the impact of repo rate?
A repurchase agreement , also known as a repo , is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and buys them back shortly afterwards, usually the following day, at a slightly higher price. A repurchase agreement , also known as a repo , RP , or sale and repurchase agreement , is a transaction concluded on a deal date t D between two parties A and B:. If positive interest rates are assumed, the repurchase price P F can be expected to be greater than the original sale price P N.
The term repo has given rise to a lot of misunderstanding: The sole difference is that in i the asset is sold and later re-purchased , whereas in ii the asset is instead pledged as a collateral for a loan: In a repo the party B acts as a lender of cash, whereas the seller A is acting as a borrower of cash, using the security as collateral ; in a reverse repo A is the lender and B the borrower. A repo is economically similar to a secured loan , with the buyer effectively the lender or investor receiving securities for collateral to protect himself against default by the seller.
The party who initially sells the securities is effectively the borrower. Many types of institutional investors engage in repo transactions, including mutual funds and hedge funds. Unlike a secured loan, however, legal title to the securities passes from the seller to the buyer.
Coupons interest payable to the owner of the securities falling due while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller. This might seem counterintuitive, as the legal ownership of the collateral rests with the buyer during the repo agreement. Although the transaction is similar to a loan, and its economic effect is similar to a loan, the terminology differs from that applying to loans: However, a key aspect of repos is that they are legally recognised as a single transaction important in the event of counterparty insolvency and not as a disposal and a repurchase for tax purposes.
Term refers to a repo with a specified end date: Open has no end date which has been fixed at conclusion. Depending on the contract, the maturity is either set until the next business day and the repo matures unless one party renews it for a variable number of business days.
Alternatively it has no maturity date — but one or both parties have the option to terminate the transaction within a pre-agreed time frame. Repo transactions occur in three forms: The third form hold-in-custody is quite rare, particularly in developing markets, primarily due to the risk that the seller will become insolvent prior to maturation of the repo and the buyer will be unable to recover the securities that were posted as collateral to secure the transaction.
The first form—specified delivery—requires the delivery of a prespecified bond at the onset, and at maturity of the contractual period. Tri-party essentially is a basket form of transaction, and allows for a wider range of instruments in the basket or pool. In a tri-party repo transaction a third party clearing agent or bank is interposed between the "seller" and the "buyer".
The third party maintains control of the securities that are the subject of the agreement and processes the payments from the "seller" to the "buyer. In a due bill repo , the collateral pledged by the cash borrower is not actually delivered to the cash lender. Rather, it is placed in an internal account "held in custody" by the borrower, for the lender, throughout the duration of the trade. This has become less common as the repo market has grown, particularly owing to the creation of centralized counterparties.
Due to the high risk to the cash lender, these are generally only transacted with large, financially stable institutions. The distinguishing feature of a tri-party repo is that a custodian bank or international clearing organization , the tri-party agent, acts as an intermediary between the two parties to the repo.
The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market , and substitution of collateral. It is this "eligible collateral profile" that enables the repo buyer to define their risk appetite in respect of the collateral that they are prepared to hold against their cash. For example, a more risk averse repo buyer may wish to only hold "on-the-run" government bonds as collateral. In the event of a liquidation event of the repo seller the collateral is highly liquid thus enabling the repo buyer to sell the collateral quickly.
A less risk averse repo buyer may be prepared to take non investment grade bonds or equities as collateral, which may be less liquid and may suffer a higher price volatility in the event of a repo seller default, making it more difficult for the repo buyer to sell the collateral and recover their cash. The tri-party agents are able to offer sophisticated collateral eligibility filters which allow the repo buyer to create these "eligible collateral profiles" which can systemically generate collateral pools which reflect the buyer's risk appetite.
Both the lender repo buyer and borrower repo seller of cash enter into these transactions to avoid the administrative burden of bi-lateral repos. In addition, because the collateral is being held by an agent, counterparty risk is reduced. A tri-party repo may be seen as the outgrowth of the ' due bill repo.
A due bill repo is a repo in which the collateral is retained by the Cash borrower and not delivered to the cash provider. There is an increased element of risk when compared to the tri-party repo as collateral on a due bill repo is held within a client custody account at the Cash Borrower rather than a collateral account at a neutral third party. A whole loan repo is a form of repo where the transaction is collateralized by a loan or other form of obligation e.
The underlying security for many repo transactions is in the form of government or corporate bonds. Equity repos are simply repos on equity securities such as common or ordinary shares. Some complications can arise because of greater complexity in the tax rules for dividends as opposed to coupons.
It is two distinct outright cash market trades, one for forward settlement. The forward price is set relative to the spot price to yield a market rate of return. There are a number of differences between the two structures. For this reason there is an associated increase in risk compared to repo. Should the counterparty default, the lack of agreement may lessen legal standing in retrieving collateral. In a repo, the coupon will be passed on immediately to the seller of the security.
In securities lending , the purpose is to temporarily obtain the security for other purposes, such as covering short positions or for use in complex financial structures. Securities are generally lent out for a fee and securities lending trades are governed by different types of legal agreements than repos.
Repos have traditionally been used as a form of collateralized loan and have been treated as such for tax purposes. Modern Repo agreements, however, often allow the cash lender to sell the security provided as collateral and substitute an identical security at repurchase. A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo".
So "repo" and "reverse repo" are exactly the same kind of transaction, just being described from opposite viewpoints. The term "reverse repo and sale" is commonly used to describe the creation of a short position in a debt instrument where the buyer in the repo transaction immediately sells the security provided by the seller on the open market. On the settlement date of the repo, the buyer acquires the relevant security on the open market and delivers it to the seller.
In such a short transaction, the buyer is wagering that the relevant security will decline in value between the date of the repo and the settlement date. For the buyer, a repo is an opportunity to invest cash for a customized period of time other investments typically limit tenures. It is short-term and safer as a secured investment since the investor receives collateral. Market liquidity for repos is good, and rates are competitive for investors. Money Funds are large buyers of Repurchase Agreements.
For traders in trading firms, repos are used to finance long positions, obtain access to cheaper funding costs of other speculative investments, and cover short positions in securities.
In addition to using repo as a funding vehicle, repo traders " make markets ". These traders have been traditionally known as "matched-book repo traders". The concept of a matched-book trade follows closely to that of a broker who takes both sides of an active trade, essentially having no market risk, only credit risk.
Currently, matched-book repo traders employ other profit strategies, such as non-matched maturities, collateral swaps, and liquidity management. When transacted by the Federal Open Market Committee of the Federal Reserve in open market operations , repurchase agreements add reserves to the banking system and then after a specified period of time withdraw them; reverse repos initially drain reserves and later add them back.
This tool can also be used to stabilize interest rates, and the Federal Reserve has used it to adjust the Federal funds rate to match the target rate. Never miss a great news story! Get instant notifications from Economic Times Allow Not now. The year was also when the Indian market came to the notice of Audioboom, a UK-headquartered company that hosts, distributes and helps monetise podcasts.
Reverse repo rate is the rate at which the central bank of a country Reserve Bank of India in case of India borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.
An increase in the reverse repo rate will decrease the money supply and vice-versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market. All that you wanted to know about Reverse Repo Rate Service tax is a tax levied by the government on service providers on certain service transactions, but is actually borne by the customers.
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