Loan in the repo market involves a very little credit risk because ________

Solution

This is a contract where an investment dealer who owns securities agrees to sell them to another entity and buy them at later date at a higher price. The other entity is giving a loan to the dealer. The difference between selling price at the security and buying price at a later date is the interest it earns. This interest rate is called the repo rate. This type of structure of credit deal involves very minimal credit risk. If the borrower defaults, the lending company can keep the securities. If the lending company does not fulfill the contractual obligations, then the borrower can keep the cash (loan amount). The most common type of repurchase agreement is overnight repo, which the agreement is renegotiated each day. Longer-term agreements are called term repo.