Imagine a financial Institution like Bank which has Government securities (G-sec) but is in a need of money for a short period time.
The bank can sell its G-sec in the market to raise money, Otherwsie, it can go for REPO transaction with another financial entity like BANK.
The advantage in the second method, is that it donot have to forgo the G-sec but use it get the money for a short period of time.
So in effect, the driving factor for REPO is the short term liquidity management.
What is a REPO & Reverse REPO?
REPO or repurchase agreement is a window which enables a bank or a financial institution to borrow money in the short-term.
In the transaction, the entity in question sells government securities or bonds to the lender (another bank or institution), with an agreement to buy the securities back after a specified time and price. The difference between the sale and purchase price, the latter being slightly higher, is the interest earned by the investor or lender.
So in such a transaction, one participant sells securities to other with an agreement to purchase them back at a later date.
The trade is called a Repo transaction from the point of view of the seller and it is called a Reverse Repo transaction from point of view of the buyer.
In other words, the transaction from the borrower side is known as the REPO whereas from the Lender side is known as "Reverse REPO".
Tomorrow we will look at the sample REPO transaction and its advantages.
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