Benefits and Risks to a Repurchase Agreement

A repurchase agreement is a transaction in which one party sells a specific security to another party and then buys it back at a given time. Typically, the transaction takes place overnight or on a very short timetable. The individual selling and then repurchasing the securities is entering into a "repurchase agreement" or "repo." The individual on the other end of the transaction is said to be entering into a "reverse repurchase agreement" or "reverse repo."

Benefits of a Repurchase Agreement

A repo is similar to a secured loan. The individual party selling the security is typically in need of short-term financing due to a lack of liquidity. For example, Company A needs to place an order for 10 tractor parts. Company A has no cash to purchase these parts, but it knows an invoice for 10 tractors it recently sold will be paid tomorrow. This means Company A needs the cash today, but it will be able to repay the debt tomorrow. Instead of going into a long-term financing arrangement with interest, Company A decides it can sell a small portion of its stock and rebuy it tomorrow. Company A is risking the fact that the stock may go up by tomorrow. However, it determines obtaining the financing today is worth the risk.

Benefits of a Reverse Repurchase Agreement

On the other end, an investment management firm has some cash it is willing to use to enter into a reverse repurchase agreement with Company A. This management firm believes the stock will go up before the stock is repurchased. This means Company A would owe the management firm more in return than originally spent to purchase the stock. This would result in a profit for the management firm; essentially, the management firm is making a bet that loaning Company A money today will result in a profit. As long as the stock does not go down, though, the worst the management firm will do is break even.

Challenges to a Repurchase Agreement

On both ends of the transaction, the main challenge to a repurchase agreement is properly matching two parties. These contracts are typically very large, requiring a potential investor to have immediate cash capital in a large amount. For this reason, the investor engaging on the reverse repurchase end is typically actually a group of investors, such as a management firm or private equity group, rather than an individual.

Once the two parties are matched, both are exposing themselves to certain risks. For the party repurchasing securities, the risk is two-fold. First, there is the chance it will have to rebuy the shares at a higher price than it sold them for. The greater risk, though, is that the party will not come up with the anticipated cash to be able to rebuy the securities. In the above example, Company A was counting on an invoice payment in order to repurchase shares. If that invoice is not paid, Company A will not be able to finalize the repurchase, and it will be considered in "default." The investors will keep the collateral, in other words, the securities purchased.