Z spread
The Z-spread, also known as the zero-volatility spread or yield curve spread, is a measure of the credit risk of a bond. It is the difference between the yield of a bond and the yield of a government bond with a similar maturity, adjusted for the bond's credit risk. The Z-spread is often used to price bonds that are not traded frequently and do not have a observable market price. It is also used to determine the spread that a bond issuer would have to pay over a government bond yield to borrow money.
Z-spread applications
The Z-spread is a measure of the credit risk of a bond, and is often used in the pricing and valuation of bonds that are not traded frequently and do not have a observable market price. Here are some situations when Z-spread is used:
- Pricing of illiquid bonds: The Z-spread can be used to price bonds that are not traded frequently and do not have a observable market price. This can be useful for bonds issued by smaller companies or for bonds with unusual features such as embedded options.
- Credit risk analysis: The Z-spread can be used to measure the spread that a bond issuer would have to pay over a government bond yield to borrow money, which can be an indication of the issuer's credit risk.
- Comparison of bonds: Z-spread can be used to compare different bonds and to determine which bond offers a better yield relative to its credit risk.
- Hedging: the Z-spread is used in the pricing of certain types of derivatives that are used to hedge interest rate risk or credit risk.
- In the context of fixed income portfolio management and investment, Z-spread is used to compare the relative value of bonds with similar characteristics, such as maturity and credit rating.
It is important to note that Z-spread is just one of the many factors to consider when evaluating a bond, and it should be considered in conjunction with other measures such as credit rating, yield, and liquidity.
Z-spread calculation
The Z-spread, also known as the zero-volatility spread or yield curve spread, is a measure of the credit risk of a bond. It is calculated as the difference between the yield of a bond and the yield of a government bond with a similar maturity, adjusted for the bond's credit risk.
The calculation of Z-spread can be done using the following steps:
- Determine the cash flows of the bond, including the face value and the coupon payments.
- Estimate the bond's credit spread, which is the additional yield over a comparable government bond required to compensate for the bond's credit risk.
- Determine the spot rate curve, which is the yield curve for zero-coupon bonds.
- Use the spot rate curve and the bond's cash flows to calculate the bond's price.
- Compare the bond's price to its face value to calculate the bond's yield-to-maturity.
- Subtract the yield-to-maturity from the bond's credit spread to calculate the bond's Z-spread.
It's important to note that the Z-spread is a relative measure, it does not have an absolute value but it's used as a benchmark for other bonds.
It is important to note that the Z-spread calculation is complex and usually done by software, or specialized financial institution and it requires market data, such as government bond yield and credit spread, to be accurate.
Other types of spreads
The Z-spread is one of several types of spreads used to measure the credit risk of a bond. Other commonly used spreads include:
- Option-adjusted spread (OAS) also known as G-spread: Similar to the Z-spread, the OAS measures the difference between the yield of a bond and the yield of a government bond with a similar maturity, adjusted for the bond's credit risk and any embedded options in the bond.
- Treasury spread: Also known as the default spread, this measures the spread between the yield of a corporate bond and the yield of a government bond with a similar maturity.
- Credit spread: This measures the spread between the yield of a corporate bond and the yield of a government bond with a similar maturity, but also takes into account the credit rating of the corporate bond issuer.
- Spread over swap: This measures the spread between the yield of a bond and the yield of a similar-maturity interest rate swap.
All of these spreads are used to measure the credit risk of a bond, but they differ in how they account for different factors such as embedded options and credit ratings. The choice of spread to use depends on the specific bond being analyzed and the purpose of the analysis.
| Z spread — recommended articles |
| Risk-weighted assets — Required rate of return — Security market line — Financial exposure — Project finance — Original issue discount — Annualized rate — WACC — Incremental borrowing rate |
References
- Choudhry, M. (2005). Understanding the z-spread. Learning Curve, September.
- Leonteva, D. S. (2022). Using Market Indicators to Refine Estimates of Corporate Bankruptcy Probabilities. Финансовый журнал, 14(6), 74-90.
- Choudhry, M. (2006). Revisiting the credit default swap basis: further analysis of the cash and synthetic credit market differential. The Journal of Structured Finance, 11(4), 21-32.
