I am confused about the reverse repurchase agreement. In the section, it was discussed that the Fed will sell the securities to the bank and in return, Fed gets the cash.
How does the definition of “reverse repo” relate to that?
I got confused by the example in the chapter and the definition of “Reverse repo”.
Reverse repo - purchase of securities with the agreement to sell them at a high price at a specific future date.
Hi @FoxMcCloud! Good question.
Both reverse repos are essentially the same thing. When the Fed sells securities to banks in return for cash, it’s the banks that are buying the security from the Fed. Eventually, the Fed will sell those securities back to the banks. I think you’re struggling with the perspective - you’re looking at it through the lens of the Fed, while we name the concept after the bank’s perspective.
Reverse repos can also occur outside of the the Fed/bank relationship. For example, a corporation could perform a reverse repo with a bank. The bank buys a security (or other form of collateral) from the corporation, giving the corporation access to cash. There’s an agreement the corporation will buy back those securities from the bank in the future. In essence, the corporation gets a short term loan without having to completely lose the security (or other form of collateral).
Either way it’s performed, the ‘reverse repo’ is named after the bank’s perspective. And in both, the Fed is buying something and giving cash to a third party (either the Fed or another organization).
I hope this helps! Please let me know if you have any questions.
Brandon, I was looking at the Fed’s perspective because if the Fed wants to tighten the money supply, they need to take the cash out of the system. So Fed would need to give securities to bank in exchange for cash, the bank is giving money to the Fed causing the bank to decrease their ability to lend money to people or third parties.
I wasn’t looking at bank’s perspective.
I thought Reverse repo was one of the tools that the Fed uses to control the money supply. If that’s the case, then why would the bank want to buy securities from the Fed to tighten the money supply?
Isn’t it in the bank’s best interest to have more money to loan out?
I didn’t know that it’s also something that can occur out of the Fed/Bank relationship.
A reverse repo is a loan, and banks get paid interest to perform them, whether it be with the Fed or another party.
Let’s go through a simple example. Assume that you have a car that you don’t want to sell, but you also need $10,000 of cash for short term purposes. To obtain the cash, you and I perform a “reverse repo.” I agree to “buy” your car for $10,000 today, but you will agree to buy it back from me for $10,500 in 3 months. I hand you over $10,000, and in return, I become the owner of the car for the next 3 months. Fast forward 3 months later, you buy back the car from me for $10,500.
You gained access to $10,000 of cash for 3 months, then paid me back $10,500. The $500 difference represents the interest you’re paying me for the loan. The car was collateral in case you weren’t able to buy back the car. A reverse repo is simply a glorified secured loan.
With the context of the example above, let me answer your questions:
Brandon, I was looking at the Fed’s perspective because if the Fed wants to tighten the money supply, they need to take the cash out of the system. So Fed would need to give securities to bank in exchange for cash, the bank is giving money to the Fed causing the bank to decrease their ability to lend money to people or third parties.
Yes. The bank is essentially “loaning” money to the Fed, and they’ll be compensated for doing so. Don’t worry about how they’re being compensated, as it’s not important for the exam.
I thought Reverse repo was one of the tools that the Fed uses to control the money supply. If that’s the case, then why would the bank want to buy securities from the Fed to tighten the money supply?
Reverse repos are a tool the Fed uses to institute monetary policy. You’re right! The bank takes part in it because they’ll be compensated by the Fed.
Isn’t it in the bank’s best interest to have more money to loan out?
Yep! Think of a reverse repo as a “loan” to the Fed. Again, they’re compensated for doing this.
I didn’t know that it’s also something that can occur out of the Fed/Bank relationship.
Yep, it does occur outside of the Fed/bank relationship. I expect most test questions to focus on reverse repos performed by the Fed, although it’s possible you see a question involving a bank lending to another organization.
That totally made things easier to understand.
Thanks, Brandon!