What Is a Reverse Repo?

A reverse repo is a type of repurchase agreement that provides the seller with the opportunity to repurchase the asset sold to a buyer, usually at a specific price and within a time frame that is defined in the terms of the agreement. Contacts of this type are usually considered to be a money market instrument and are sometimes used as a means of generating capital to meet some type of pressing debt. Once the debt is discharged and the seller is able to secure other funding, the asset sold as part of the reverse repo can be repurchased, allowing the original owner to once again to make use of the asset as he or she sees fit.

One of the more common applications of a reverse repo transaction has to do with the raising of capital that is needed sooner rather than later. In this scenario, a business may choose to sell a non-essential asset to a buyer as a means of generating revenue that can be used to discharge a pressing debt. As part of the sale terms and conditions, the buyer agrees to sell the asset back to the original owner on or by a date identified in the contract terms. Typically, the price for this type of repo sale is also identified in the provisions, with that price often being slightly more than the buyer originally paid for the purchase of the asset. This arrangement allows the company to pay off the debt and eventually repurchase the asset at a cost that is less than taking out a business loan or using a business line of credit, and incurring interest charges that must be repaid along with the principal.

Another application of a reverse repo has to do with the sale and repurchase of securities traded on the open market. Here, the goal is often to sell the securities while retaining a covenant to repurchase those same securities at a specified date in the future. The hope of the seller is that in the interim those securities will experience a temporary downturn, allowing them to be repurchased at a lower rate. Assuming the securities are anticipated to begin increasing in value once again after the repo portion of the transaction is complete, the investor stand to make a handsome return on the arrangement.

There is some degree of risk associated with a reverse repo arrangement, especially if the deal involves the sale of volatile securities. Should the securities involved fail to decrease in value during the period between the initial sale and the repurchase date, the original owner could incur a loss. In addition, if the repurchased securities do not recover and continue to decline in value, a loss is also created. For this reason, using securities as part of a reverse repo strategy calls for understanding the potential of those options, accurately projecting their future movement, and arranging the terms of the repo agreement to produce the desired result.