Repo and Reverse Repo Rate

Topics: Stock exchange, Stock market, London Stock Exchange Pages: 6 (1503 words) Published: March 8, 2011
Repo and reverse repo rate
These are the rates which are used by reserve banks (RBI in India) to inject or absorb liquidity from banking system. Repo rate is the rate at which the RBI lends money to the commercial banks or the rate it which banks borrow money from RBI. When RBI increases repo rate borrowing from RBI becomes more expensive. RBI increases repo rate to make it more expensive for the banks to borrow money. If RBI reduces the repo rate means banks can borrow money at cheaper rates. The term repo comes from repurchase agreement. This is known as repurchase agreement because bank makes an agreement with reserve bank to repurchase bonds, which are kept with RBI for borrowing money to meet banks cash needs. This is the rate at which liquidity is injected in banking system by RBI. Reverse Repo rate is the rate at which banks keep their money with the RBI or the rate at which RBI borrow money from commercial banks. The RBI uses this tool when it feels there is too much liquidity in the banking system. If RBI increases reverse repo rate means RBI is ready to borrow money from banks at higher rate of interest then banks would prefer to keep more money with RBI instead of making investment and providing loans at low interest rates. As a consequence of this loan interest rate will increase, that will help in controlling liquidity. Thus Reverse repo rate is the rate at which the central bank absorbs or draws liquidity from the banking.

What is cash reserve ratio – CRR
Banks require keeping a certain percentage of total deposits in form of cash.CRR is the amount which scheduled commercial banks have to keep with RBI (Reserve Bank of India).This ratio is decided by RBI and used to control liquidity. If RBI makes a decision to reduce CRR, then banks have to keep fewer amounts in form of cash with RBI. There will be more amounts available with commercial banks for lending and investment, now bank can reduce interest rates on various loans to utilize this excess fund. Thus this instrument is used by RBI and affects economy, inflation and interest rates. This is also known as the liquidity ratio and cash asset ratio. It can be between three to twenty percent in India.

Types of Investments

The various types of investment are:
• Cash investments: These include savings bank accounts, certificates of deposit (CDs) and treasury bills. These investments pay a low rate of interest and are risky options in periods of inflation.

• Debt securities: This form of investment provides returns in the form of fixed periodic payments and possible capital appreciation at maturity. It is a safer and more 'risk-free' investment tool than equities. However, the returns are also generally lower than other securities.

• Stocks: Buying stocks (also called equities) makes you a part-owner of the business and entitles you to a share of the profits generated by the company. Stocks are more volatile and riskier than bonds.

• Mutual funds: This is a collection of stocks and bonds and involves paying a professional manager to select specific securities for you. The prime advantage of this investment is that you do not have to bother with tracking the investment. There may be bond, stock- or index-based mutual funds.

• Derivatives: These are financial contracts the values of which are derived from the value of the underlying assets, such as equities, commodities and bonds, on which they are based. Derivatives can be in the form of futures, options and swaps. Derivatives are used to minimize the risk of loss resulting from fluctuations in the value of the underlying assets (hedging).

• Commodities: The items that are traded on the commodities market are agricultural and industrial commodities. These items need to be standardized and must be in a basic, raw and unprocessed state. The trading of commodities is associated with high risk and high reward. Trading in commodity futures requires specialized knowledge...
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