How does a repurchase agreement (repo) transaction work step by step, and what are the risks involved?

Question

AcadiFi · Accepted Answer

Repurchase agreements (repos) are the backbone of short-term funding markets and a key FRM Part I topic. A repo is economically equivalent to a collateralized loan, but legally structured as a sale and repurchase of securities. Here is the full lifecycle.

**Repo Mechanics — Two Legs:**

```mermaid
sequenceDiagram
  participant Dealer as Oakmont Securities (Cash Borrower)
  participant Lender as Meridian Fund (Cash Lender)
  Note over Dealer, Lender: Opening Leg - Day 0
  Dealer->>Lender: Sells $100M Treasury bonds
  Lender->>Dealer: Pays $98M cash (2% haircut)
  Note over Dealer, Lender: During Repo Term
  Lender-->>Lender: Holds bonds as collateral
  Note over Dealer, Lender: Closing Leg - Day 30
  Dealer->>Lender: Pays $98M + repo interest ($122,500)
  Lender->>Dealer: Returns $100M Treasury bonds
  Note over Dealer, Lender: Repo Rate = 1.50% annualized
```

**Step-by-Step Walkthrough:**

**Day 0 — Opening Leg:**
Oakmont Securities needs $98 million in overnight or term funding. It owns $100 million face value of 10-year Treasury bonds. Oakmont sells the bonds to Meridian Fund for $98 million — a 2% haircut that protects the lender against collateral value decline.

**During the Term (30 days):**
Meridian holds the Treasury bonds. If their market value drops below the agreed threshold, Meridian can issue a **margin call** requiring Oakmont to post additional collateral or cash. This is analogous to futures margin but applied to the repo.

**Day 30 — Closing Leg:**
Oakmont repurchases the bonds by paying the original $98 million plus repo interest:
Repo Interest = $98,000,000 x 1.50% x (30/360) = **$122,500**
Total repurchase price = **$98,122,500**

**Key Pricing Components:**

| Component | Description | Example Value |
|---|---|---|
| Collateral value | Market value of pledged securities | $100,000,000 |
| Haircut | Discount protecting lender from price drops | 2.0% |
| Cash advanced | Collateral value x (1 - haircut) | $98,000,000 |
| Repo rate | Annualized interest rate on cash | 1.50% |
| Repo term | Duration of the agreement | 30 days |
| Repo interest | Cash x rate x (days/360) | $122,500 |

**Factors Affecting the Repo Rate:**
1. **Collateral quality:** Treasuries command the lowest rates (general collateral). Corporate bonds or equities require higher rates and larger haircuts.
2. **Term:** Overnight repos have lower rates than term repos (30, 60, 90 days).
3. **Counterparty credit:** A weaker borrower pays a higher repo rate.
4. **Market conditions:** In stressed markets, repo rates spike as lenders demand higher compensation.

**Risks in Repo Transactions:**
- **Counterparty risk:** If Oakmont defaults, Meridian keeps the collateral but may face replacement risk if rates have moved.
- **Collateral risk:** If Treasury prices drop sharply and Oakmont cannot meet margin calls, Meridian may sell collateral at a loss.
- **Rollover risk:** If Oakmont relies on overnight repos for term funding, it faces a liquidity crisis if lenders refuse to roll over.
- **Fire-sale risk:** In a systemic crisis, multiple dealers liquidating repo collateral simultaneously depresses prices — this amplified the 2008 crisis.

**Exam Tip:** The FRM exam loves testing haircut calculations and the distinction between general collateral (GC) repos and special repos (where a specific bond is in high demand, driving the repo rate below GC levels).

For more on money market instruments and funding risk, explore our FRM Part I Financial Markets module.

How does a repurchase agreement (repo) transaction work step by step, and what are the risks involved?

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