The repurchase agreement (repos) market affords additional liquidity to the money market. Firms are able to raise additional capital by selling securities held in inventory to another institution with an agreement to buy them back at a specified higher price at a specified time. In effect, a repurchase is a short-term loan. The securities are usually government securities. Because of concerns about default risk, the length of maturity of repurchase agreement is usually very short. Typically, repos are used for overnight borrowing needs.

        As an example of how repos work, suppose that for cash management purposes, Ford Motor Corporation holds $4 million in three-month U.S. Treasury bills yielding 5%. Now Ford has an immediate need for $4 million so it can purchase a specialized piece of equipment being offered at a bankruptcy liquidation. Ford’s cash manager also knows that in a week, Ford will receive $4 million payment for auto sales in Canada. What can Ford do?

        One solution would be to take a bank loan at, say, 11% Ford could also sell the T-bills and buy them back in one week. Ford would incur two transaction costs when the bills had to be repurchased. In additional, there would be price risk in this transaction: the price of the T-bills could rise in a week. Alternatively, Ford could enter into a repurchase agreement using its T-bills. Ford could sell the T-bills to an outside firm with a guarantee to buy them back in two weeks at a specified price. From the difference between the sale price and the purchase price, an implied interest rate, known as the repo rate, can be computed. Obviously, Ford should employ the transaction that is the cheapest after all transaction costs are considered.

    The firm that holds short-term financial assets and, in particular, bank deposits, can invest in the repo market. The firm can make more money than it can earn in deposit accounts, and with a lower risk. How is this possible? Security dealers who need to borrow money are allowed to enter the deposit market. Therefore, they are willing to pay a firm that lends them money in a repo agreement a very high interest rate. In additional, a firm that lends money to dealers holds the securities as collateral, whereas the deposits in the bank are uninsured. Thus, a higher return and a lower risk on the firm’s money is obtained compared with a bank deposit. For example, by investing in repos, Dupont/Canoco reports an annual income increase of $2 million.
    There are many variations in the design of repurchase agreements. A term repo has a longer holding period. A reverse repo is the opposite of a repo. In this transaction, a corporation buys the securities with an agreement to sell them at a specified price and time. The repo market was about $190 billion at the end of 1996.
    The federal funds market help banks place reserves on deposit at the Federal Reserve Bank. Banks that do not have sufficient funds on reserve can borrow from other banks that have excess reserves. Most of this borrowing is for one day, “although some agreements are for as long as six month.
    Finally, Eurodollars are U.S. dollar deposits held outside the United States. These deposits are not subject to the same regulations as bank deposits held within the United States. Hence, the interest rate offered on Eurodollar deposits is typically different from the rate offered in the United States. The interest rate quoted for these deposits between major banks is referred to as LIBOR, or London Interbank Offer Rate. It is the rate that one book asks from another bank for borrowing. London is the main trading center for Eurodollars. The LIBID, or London Interbank Bid Rate, is the rate at which major banks will offer Eurodollars as deposits to other banks. The interest on loans is sometimes linked to the LIBOR. Quotes such as “LIBOR + 1%” or “LIBOR +2%” are very common, where the riskier the borrower, the higher the increase in the interest rate above the LIBOR.