Reverse Repurchase Agreement

Definition

A Reverse Repurchase Agreement (RRP) or reverse repo refers to the sale of securities with an agreement to repurchase them at a higher price on a specific future date. The reverse repo is the seller in a repurchase agreement (RP) or repo. These transactions typically occur between two banks and are essentially secured loans.

Origin

The reverse repurchase agreement originated from the need for short-term liquidity management in financial markets. The earliest repo transactions date back to the early 20th century, but reverse repos became widely used as a regular financial tool in the late 20th century, especially in central bank monetary policy operations.

Categories and Features

Reverse repurchase agreements can be categorized by term into overnight reverse repos and term reverse repos. Overnight reverse repos are typically completed within a day, while term reverse repos can last from several days to weeks. The main features of reverse repos are their role as a low-risk short-term investment tool, providing liquidity and interest income.

Case Studies

A typical case is the Federal Reserve using reverse repurchase agreements to manage liquidity in the banking system. Through reverse repos, the Fed can absorb excess cash from the market, thereby controlling interest rates. Another case is the People's Bank of China using reverse repos in monetary policy operations to regulate market liquidity and ensure stability in the interbank market.

Common Issues

Investors using reverse repos may encounter issues such as sensitivity to interest rate changes and the risk of insufficient market liquidity. A common misconception is that reverse repos are risk-free, whereas changes in market conditions can affect their yield.