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Financial Markets and Trading Anaylsis


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Question 2

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1 Question 2 on Sat Aug 06, 2011 2:52 am

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My current answer to Question 2 - this may change as I review all of my answers before submitting the exam (for example, I'm thinking of adding a simple diagram):

At its most basic a "repo" or Repurchase Agreement is a method of bringing together
providers and users of capital - to transfer an excess of capital to where it is needed.
More simply, Repurchase Agreements are a form of short-term borrowing and as such are
classified as money-market instruments. A Repurchase Agreement and Reverse Repurchase
Agreement represent different sides of the same transaction.

The Repurchase Agreement represents an agreement for a borrower to sell some kind of
security along with an agreement to re-purchase the security at a future date at a higher
price. The difference between the prices is effectively the interest paid on borrowing money.
The original seller of the securities (borrower) enters into a Repurchase Agreement.
This represents one side of the transaction.

The other side of the transaction is the Reverse Repurchase Agreement and represents an
agreement of the lender to sell the securities back to the borrower at a higher price at a
future date.

In summary a Repo involves securities being sold with an agreement to buy back in the
future at a higher price. A Reverse Repo involves securities being bought and sold back in
the future at a price greater than they were originally bought for.

Central banks of countries use Repos and Reverse Repos to adjust the availability of money
with the aim of increasing or decreasing interest rates. For example, the US Federal Reserve
can buy US Treasury securities with an agreement to sell them back at a future date. In
this scenario the US Federal Reserve has entered into a Reverse Repurchase Agreement
since they are effectively lending money, while commercial banks enter into a Repurchase
Agreement. If the Federal Reserve buys securities from US banks, then short-term lending
to banks is achieved, liquidity is injected into the banking system and interest rates are
reduced.

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