A repurchase agreement is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. It is actually a collateralized loan. The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan. The implied interest rate is called the repo rate.

A loan for one day is called an overnight repo. A loan for more than one day is called a term repo. If a repo agreement lasts until the final maturity date, it is known as a "repo to maturity."

The repo rate is lower than the cost of bank financing. It is a function of a few factors, including the risk associated with the collateral, the term of the repo, the delivery requirement for the collateral, the supply and demand conditions of the collateral, and the interest rates of alternative financing in the money market. The more difficult it is to obtain the collateral, the lower the repo rate. Hot collateral or special collateral is collateral that is highly sought-after by dealers and can be financed at a lower repo rate than general collateral.

The initial margin represents the initial amount of cash or securities that the borrower must provide to the lender to secure the transaction. It serves as a form of security for the lender in case the borrower defaults on the repo. initial margin = security price₀ / Purchase Price₀

When a lender imposes a high margin haircut, it means they require a larger percentage of collateral compared to the value of the loan. For example, if the lender requires a 5% margin haircut on a $1 million loan, the borrower would need to provide collateral with a value of $1.05 million. The purpose of a margin haircut is to protect the lender from potential losses if the value of the collateral decreases or if the borrower defaults.

From a dealer's perspective, if it is lending cash, the repo is then referred to as a reverse repurchase agreement.

Credit risks are faced by both parties. The difference between the market value of the security used as collateral and the value of the loan is the repo margin. It is most likely to be lower when:

• The maturity of the repo is short.
• The quality of the collateral is high. Market risk arises from the possibility of a change in the market value of the securities used as collateral. Market risk can be particularly relevant when repos involve securities that are subject to price volatility.
• The credit quality of the counterparty is high.
• The underlying collateral is in short supply or there is a high demand for it.

Other Risks:

Liquidity Risk: Liquidity risk refers to the potential difficulty of selling or repurchasing the securities in the market, especially during stressed market conditions. If the lender needs to sell the collateral before the repo term expires, they may face challenges in finding buyers or obtaining a fair price. This risk is particularly significant for less liquid securities or during periods of market stress.

Roll-over Risk. Repos are often rolled over or renewed after their initial term expires, allowing both parties to extend the agreement. However, roll-over risk arises when the borrower is unable to renew the repo, leaving the lender with funds that need to be reinvested elsewhere. If suitable investment opportunities are limited, the lender may face challenges in earning a comparable return.

Regulatory Risk. Regulatory changes or new requirements imposed on the repo market can introduce additional risks. For example, changes in capital adequacy rules for financial institutions may impact their willingness or ability to engage in repo transactions, potentially reducing market liquidity.

Operational Risk. This relates to potential errors, disruptions, or failures in the operational processes and systems associated with repo transactions. This risk could include mistakes in documentation, settlement failures, or technological glitches that may impact the smooth execution of the agreement.