As per the Reserve Bank of India ,'Repo or ready forward contract is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed,. This can be illustrated with the help of an example.
Suppose PNB wants to do Repo transaction with RBI. For doing Repo transaction, it uses a 10 year 01-Mar-2020 Central Government Security which pays a coupon of 8%.The security has a face value of Rs. 100 and is currently trading at Rs.110. PNB has 1 lakh of this security. This means that the face value of the security is Rs. 1 crore. However, when the repo happens, this will be done at value of Rs. 1.1 crores as the price of the security is Rs. 110 This means that in the repo transaction, market price of the security as decided by RBI is taken into consideration and not the face value. Apart from the market price, the accrued interest is also considered. Accrued interest means the interest due from last coupon date which has not been paid yet. Interest is paid on semi-annual basis for government securities. In the example above, since 01-Mar-2020 is the maturity date of security there will be two coupon dates in the year, 01st Sep and 1st Mar. If the repo transaction is done on 01st Jul of a year, then the accrued interest till 01st Jul will be calculated and added in the value of security. Just to repeat, value of the security is its market price.
Hence in the first stage of repo transaction, PNB will borrow the fund from the RBI by depositing the 10 year GOI security. RBI will pay the amount equal to current value of the security plus accrued interest to PNB and PNB will deposit security with RBI. Suppose the repo is being done for 3 days. After three days, PNB will return the funds to RBI and RBI will give security back to PNB.
What is the earning of RBI from repo transaction? If the RBI keeps the security for three days, the accrued interest for 3 days will be given by PNB to RBI. Apart from this, PNB will also pay RBI a kind of interest called as repo rate. Repo rate is decided by RBI from time to time and it will be calculated on the amount which RBI has lent to PNB (Market value of the security plus accrued interest). So the total earning in repo transaction for RBI is the repo rate (converted into an amount depending upon market value of the security) plus the accrued interest for the period for which repo transaction is done.
The RBI defines reverse repo as ,' The reverse of the repo transaction is called 'reverse repo' which is lending of funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.'
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