REPURCHASE AGREEMENTS

Repurchase agreements are considered to be money market financial instruments. Money market financial instruments, in turn, consist of short-maturity or short-term financial instruments. A financial instrument is considered "short-term" if it matures within one year. This definition of "short-term" as used for money market purposes is different from that used by the Internal Revenue Service, which uses six months as the cut-off between short and long terms. Among the many money market instruments, repurchase agreements are among those that have the shortest maturity periods. Based on maturity period, repurchase agreements are usually classified under two sub-groups—overnight repurchase agreements and long-term repurchase agreements.

OVERNIGHT REPURCHASE AGREEMENTS

Repurchase agreements, or RPs, are essentially short-term loans backed by Treasury bills as collateral. Usually, the maturity period of a repurchase agreement is less than two weeks, overnight RPs being the shortest maturity repurchase agreement instrument. A repurchase agreement transaction can be illustrated as follows: corporation A has some idle cash and corporation B wants to borrow funds overnight to make up for the shortfall in the amount of required reserves that it must have at the Federal Reserve. Assume that corporation A uses $10 million to buy Treasury bills from corporation B, which agrees to buy back (repurchase) Treasury bills the next morning at a price slightly higher than corporation A's purchase price. The higher price that corporation B pays is a form of interest on the overnight use of corporation A's $10 million. Thus, in effect, corporation B borrows $10 million from corporation B for overnight use at a specified interest (implied in the purchase and repurchase prices of Treasury bills). Should corporation B not buy back the Treasury bills that corporation A is holding, the latter can sell those bills to its loan. Transferred Treasury bills thus serve as collateral, which the lender receives if the borrower does not pay back the loan.

Repurchase agreements are a relatively new financial instrument. They have been in existence only since 1969. However, they constitute an important source of funds for banks, where large corporations are considered the most important lenders.

Because of extremely short maturity, overnight repurchase agreements are considered very liquid—the instrument turns back into cash the very next day. Since RPs are liquid, but less liquid than currency or checkable deposits, they are included, by the Federal Reserve, in broader definitions of money supply.

LONGER-TERM REPURCHASE
AGREEMENTS

Repurchase agreements that have maturity periods of more than one night are called long-term repurchase agreements, or term RPs. Thus, long term repurchase agreements also facilitate borrowing and lending in which Treasury bills are essentially used as collateral. By nature, long-term repurchase agreements are less liquid than overnight repurchase agreements.