Reverse Repurchase Agreement
Reverse repurchase agreement refers to a type of agreement on purchase of securities upon the agreement to resell them at a high price at a future date. For the trader selling and agreeing they will purchase it in the near future, it is known as a repo while for the party buying the securities and making the agreement to sell in future, it is known as reverse repurchase agreement.
Repos are known as money-market instruments and they are used for purposes of raising short term capital. This is often a practice in which a financial institution or a bank purchases securities or other assets with the knowledge it will resell the asset or securities to that same seller. Financial institutions and investors agree to a reverse purchase agreement for purposes of raising short term capital. In actual sense, repos are the equivalent of short term loans with assets and securities serving as the collateral. Reverse repurchase agreement is not different from a repurchase agreement the only difference is that it is the buyer’s perspective rather than that of the seller. Consequently it is also known as a reverse or matched sale transaction.
For instance if A wants to sell securities to an investment firm B, then the firm should have cash it is ready to use in order to get into a reverse repurchase agreement with A. The management firm operates by the belief the price of the stock will rise before it is repurchased. If this happens, then the company selling the stock will return a higher price to company B than what was initially paid. As a result, the management firm makes a profit. However, it is ideal to note this only happens as long as the stock remains high and does not fall.
A reverse repurchase agreement can also face challenges. Key among them is that of properly matching 2 parties. This type of agreement is usually large requiring the potential investor to have immediate capital in huge amounts. As such, the investor requesting for reverse repurchase usually tends to be a group of investors like a private equity group or management firm rather than individuals.
Once the parties are matched, both get exposed to certain risks. For those repurchasing securities they are exposed to risks that are twofold. For starters, there is the possibility they will repurchase those shares at a high price compared to what they sold them at. Secondly, there is the possibility they might not be able to raise the cash needed to repurchase the securities. When this happens, it means that the investors have the right to retain the collateral which is in this case refers to the securities bought.
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