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Repurchase agreement (repo)
Essentially a collateralised loan, a repo is a type of securities financing transaction. It is also known as a sale-and-repurchase agreement in some markets. The principal use of repo is borrowing and lending cash.
A repo involves the seller of an asset – typically a fixed income security – agreeing to buy it back at a later time, either on a fixed date (a term repo) or on demand (an open repo). When buying the asset back, the seller pays the buyer a mark-up, which is equivalent to interest on a loan – it is quoted as a percentage-per-annum rate and called the repo rate.
For the buyer of the security who agrees to sell it back in the future the transaction represents a reverse repo.
The seller of the repo could be a bank or broker-dealer, and the buyer a money market fund with cash that might otherwise sit idle. The seller is able to generate a return from securities it holds without actually having to sell them, by reinvesting the cash from the buyer of the repo. Repo makes markets more liquid, as the collateral circulated can then be used to facilitate other transactions.
The buyer of a repo receives the security as collateral against the default of the seller; if the seller defaults the new owner can sell the asset to a third party.
Central banks also use repos. As an instrument of monetary policy, the repo rate set by central banks allows governments to regulate money supply. A decrease in repo rates encourages banks to sell securities back to the government in return for cash, increasing money supply. Conversely, increasing repo rates discourages banks from reselling securities.
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