First and most obvious, the mea- sure assumes the reference rate will not change over the securitys life. Second, the price of a floater for a given discount margin is sensitive to the path that the reference rate takes in the future except in the special case when the discount margin equals the quoted margin.

Option-Adjusted Spread

The spread measures discussed thus far fail to recognize any embedded options that may be present in a floater. A spread measure that takes into account embedded options is the option-adjusted spread. A discus- sion of how this spread measure is computed is beyond the scope of this chapter.4Basically, it is a byproduct of a model that is used for valuing a security with an embedded option. The spread is referred to as "option adjusted" because the valuation model adjusts the cash flows based on how changes in the reference rates might be expected to change the cash flows of the security, taking into account any embedded options.

Despite its widespread use, the OAS has a number of limitations. Specifically, the OAS is model-dependent. Changing the assumptions of the valuation model may produce substantial differences in the com- puted OAS.

4See Chapter 4 in Frank J. Fabozzi and Steven V. Mann, Floating-Rate Securities (New Hope, PA: Frank J. Fabozzi Associates, 2000).

CHAPTER8

RepurchaseandReverse

Repurchase Agreements ne of the largest segments of the money markets worldwide is the market in repurchase agreements or repos. A most efficient mechanism by which to finance bond positions, repo transactions enable market makers to take long and short positions in a flexible manner, buying and selling according to customer demand on a relatively small capital base. Repo is also a flexible and relatively safe investment opportunity for short-term investors. The ability to execute repo is particularly important to firms in less-developed countries who might not have access to a deposit base. Moreover, in coun- tries where no repo market exists, funding is in the form of unsecured lines of credit from the banking system which is restrictive for some market par- ticipants. A liquid repo market is often cited as a key ingredient of a liquid