FRM Exam Part II · Repurchase Agreements and Financing

Repurchase Agreement Mechanics: Repo and Reverse Repo Explained

Updated 11 October 2026 · Fact-checked

A repurchase agreement is a sale of securities for cash with a promise to buy them back later at a higher price. The price difference is interest at the repo rate. The cash lender holds collateral, protected by a haircut. To solve questions, identify each party's side, then compute cash, repurchase price and haircut.

Understand Repurchase Agreement Mechanics

A repo is a short-term secured loan built as two trades. On the start date (the near leg), the seller of securities delivers collateral and receives cash. On the maturity date (the far leg), the seller buys the securities back and pays cash plus interest. Economically, the seller is borrowing cash and the buyer is lending it.

The same trade has two names. The party that sells the collateral and borrows cash is doing a repo. The party that buys the collateral and lends cash is doing a reverse repo. It is one transaction seen from two sides. A dealer funding its bond inventory does repo. A money market fund investing spare cash does reverse repo.

Interest is the repo rate, quoted as an annualised simple rate, usually on an Actual/360 basis for USD. The repurchase price is the cash lent plus interest. The lender is exposed to the borrower's default, but holds collateral it can sell. The borrower is exposed too, because the lender holds more value than it lent.

To cover the risk that collateral falls in value, the lender lends less than the collateral's market value. This gap is the haircut (or initial margin). With a 5% haircut, ₹100 of collateral raises ₹95 of cash. The cash lent is the market value of collateral × (1 − haircut). Some markets quote initial margin as collateral value ÷ cash, so a 105% margin corresponds to roughly a 4.76% haircut. Read which convention is given. After the trade starts, variation margin (margin calls) restores cover as collateral prices move.

Collateral can be general collateral (GC), meaning any acceptable security of a type such as government bonds, which trades near the general repo rate. It can also be special, meaning a particular security in high demand, often to cover shorts. Cash lenders accept a lower repo rate to receive a special security, so a special's repo rate sits below the GC rate. The gap is the specialness. A low or negative repo rate signals the security is scarce.

Key formulas to remember

Cash lent with a haircut: Cash = Collateral market value × (1 − haircut); Haircut is a percentage of collateral value, not of cash.
Repurchase price: Repurchase price = Cash × (1 + repo rate × days ÷ 360); Use 365 for GBP and some other markets. Simple interest, not compounded, for a term repo.
Repo interest: Interest = Cash × repo rate × days ÷ day-count basis; Paid by the repo seller (cash borrower) to the cash lender.
Initial margin ratio: Margin ratio = Collateral value ÷ Cash lent = 1 ÷ (1 − haircut); A 5% haircut equals a margin ratio of about 105.26%.
Specialness: Specialness = GC repo rate − special repo rate; Positive for a security in demand. The special rate is lower than GC.

How to solve Repurchase Agreement Mechanics questions

Use this order for any repo mechanics question. It keeps the sides, the money and the rates from getting mixed up.

1Identify who delivers collateral and who delivers cash. The collateral giver is the repo party and the cash giver is the reverse repo party.
2Note the collateral market value, haircut or margin ratio, term in days and day-count basis.
3Compute the cash lent: collateral value × (1 − haircut). If margin is quoted as a ratio, divide collateral by the ratio.
4Compute interest: cash × repo rate × days ÷ basis. Add it to cash for the repurchase price.
5If prices move, compare current collateral value with cash plus interest times the required margin to find any margin call, and who must post.
6For GC versus special questions, compare the repo rate with GC. A lower rate means the collateral is special and in demand.
7Check the answer: the repurchase price must exceed cash lent, and cash lent must be below collateral value.

Quickest way: Three-line repo check

When to use it: Use when a multiple-choice question gives a haircut, rate and term and asks for cash, interest or repurchase price.

Cash = collateral × (1 − haircut).
Interest = cash × rate × days ÷ 360.
Repurchase price = cash + interest. Eliminate any option where cash lent equals collateral value or where interest is based on collateral value.

Common mistakes in Repurchase Agreement Mechanics

Calling the cash lender the repo party
Students think 'repo' means lending because the word sounds like a purchase.
Fix: Repo means selling collateral and borrowing cash. The cash lender is doing a reverse repo.
Applying the repo rate to collateral value
The collateral looks like the principal of the trade.
Fix: Interest accrues on the cash actually lent, which is after the haircut.
Treating the haircut as a charge paid in addition
Haircut sounds like a fee.
Fix: The haircut reduces cash received against the collateral. It is a buffer, not a cost, and it is returned at maturity through the unwinding of the trade.
Thinking a special has a higher repo rate
Scarce assets seem like they should cost more.
Fix: The cash lender gets the scarce security, so it accepts a lower rate on its cash. Special rate is below GC.
Confusing a haircut with the margin ratio
Both express the same buffer but in different bases.
Fix: Haircut = 1 − cash ÷ collateral. Margin ratio = collateral ÷ cash. Convert before computing.

Worked examples

Example 1

A dealer repos US Treasury bonds with market value USD 50,000,000 for 30 days. The haircut is 2% and the repo rate is 4.50% on an Actual/360 basis. Find the cash received and the repurchase price.

Show the solution

Cash received = 50,000,000 × (1 − 0.02) = USD 49,000,000.
Interest = 49,000,000 × 0.045 × 30 ÷ 360 = 49,000,000 × 0.00375 = USD 183,750.
Repurchase price = 49,000,000 + 183,750 = USD 49,183,750.

Answer: Cash received is USD 49,000,000 and the repurchase price is USD 49,183,750.

Example 2

A bank lends cash against collateral worth EUR 20,000,000 with an initial margin of 105% (collateral ÷ cash). The general collateral repo rate is 3.00%. A particular bond used as collateral trades at a repo rate of 1.20%. What is the cash lent, the haircut equivalent, and the specialness?

Show the solution

Cash lent = 20,000,000 ÷ 1.05 = EUR 19,047,619 (rounded).
Haircut = 1 − 1 ÷ 1.05 = 1 − 0.95238 = 4.76% (rounded).
Specialness = GC rate − special rate = 3.00% − 1.20% = 1.80%.
The bank, as cash lender, receives a scarce bond and accepts a lower return on its cash.

Answer: Cash lent is about EUR 19,047,619, the haircut is about 4.76%, and the specialness is 1.80 percentage points.

Exam tips

Always state first which side the question asks about. Many wrong options are the right number for the wrong party.
Check whether the question gives a haircut or a margin ratio. They are different bases.
Expect a day-count trap. Use 360 unless the question says 365.
Link specials to short covering: a very low or negative repo rate means high demand for that bond.
For risk questions, remember haircuts protect the cash lender, and larger haircuts are applied to more volatile or less liquid collateral.

Practice questions from Repurchase Agreements and Financing

Repurchase Agreement Mechanics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CFA Level IShort-Term Funding: Repo and Commercial Paper

Repurchase Agreement Mechanics: frequently asked questions

What is the difference between repo and reverse repo?

They are the same transaction from opposite sides. The party selling securities and borrowing cash does a repo. The party buying securities and lending cash does a reverse repo.

What does a repo haircut do?

It makes the lender advance less cash than the collateral is worth. This buffer protects the lender if collateral falls in value before it can be sold after a default.

What is the difference between general collateral and special collateral?

General collateral is any acceptable security in a class, such as government bonds, and trades near the general repo rate. Special collateral is a specific security in high demand, and its repo rate is lower than the GC rate.

Who pays the repo interest?

The repo seller, who borrowed the cash, pays interest to the cash lender. It is built into the higher repurchase price on the far leg.