Benjiko

Okay, before understanding Z-Spread, you need to understand there are 2 Measures that explain a Bond's Price.

1. One is YTM Measure: This is ONE/SINGLE/SAME discount rate, that you use, to discount ALL future cashflows from a Bond, such that the result equals its current Market Price. And because you are using ONE/SINGLE/SAME discount rate for all its cashflows, it gives rise to the assumption that you are going to hold the bond till maturity and you will re-invest any cash that you get from it in between, at that same interest rate (discount rate / YTM).

2. Another measure is SPOT RATE Measure: That is, you apply DIFFERENT Discount Rates for your periodic cashflows from your bond, such that after all discounting your result is same as the current Market Price of that Bond.

Now, after knowing the 2 Measures, the 2 Spreads are derived from these 2 Measures.

1. Nominal Spread: (based on YTM measure) It is the difference between your Bond's YTM with a Treasury Bond's YTM of the same maturity.

2. Z-Spread: (based on Spot Rate Measure) It is a constant number, that you add to various Treasury Spot Rates, to use in discounting your various cashflows from your Bond to get to its Market Price.

Basically, both these spreads are trying to measure Risks associated with that Bond as compared to a Treasury (risk free) bond.

Hope this helps.

Edit: If there are any queries, I will be glad to discuss further.



Edited 1 time(s). Last edit at Tuesday, September 29, 2009 at 10:53PM by rus1bus.