The term repo stands for repurchase agreement. Securities dealers carry large inventories of bonds for they need to stand ready to sell whenever an investor seeks to buy. Typically, the capital invested by the dealer in the business will be very small compared to the value of securities that he is carrying.
A dealers debt equity-ratio may be of a magnitude that is as high as something like 40:1. That is for every $41 worth of securities being carried by him, $40 is funded with borrowed money. Repurchase agreements facilitate the borrowing by dealers to fund their inventories.
A repurchase agreement is essentially a collateralised loan agreement. Take the case of a dealer who has securities worth $100 and seeks to borrow. He can enter into an agreement with a party willing to lend, whereby he agrees to sell the securities for $100 with a simultaneous agreement to repurchase it at a slightly higher price.
As can be seen, this is essentially a collateralised borrowing arrangement. The difference between the sale price and the purchase price constitutes interest income for the party who is offering to buy the securities.
The securities themselves constitute collateral, for if the dealer who borrows reneges on his commitment to buy them back, the lender can have them sold to recover the amount lent. In some cases the sale and purchase price for the securities will be identical and the interest will be separately calculated and paid.
In practice, a dealer who offers securities that are currently valued at $100, will not get a loan for the same amount. This is because the lender will seek to protect himself against a sharp decline in the value of the collateral and will consequently agree to lend a lower amount. If a lender were to lend $95 against an offer of securities that are currently valued at $100, we would say that he has applied a haircut of 5%.
Sometimes, the asset being offered as collateral will pay a coupon during the period that it is with the lender. In such cases, the understanding is that the lender will collect and pass on the cash to the borrower.
This is because while there is a transfer of ownership legally, the borrower continues to be the beneficial owner of the securities.
Due to market fluctuations, the collateral value may increase or decrease. If it were to decline in value, the lender will ask for more