Hi Could someone explain to me why the difference between the nominal spread and the z-spread increases when the slope of the spot rate curve increases? Thanks!
The nominal spread is the simple difference in YTM of a treasury security and a non-treasury (corporate, muni, etc) security with the same maturity, whereas the Z-spread is the equal amount that we must add to each rate on the Treasury spot yield curve to make the present value of non-Treasury securitie’s cash flows equal to it’s market price. I guess the easiest way to exaplain it is that we are discouting the cash flows, so a steeper yield curve means we have to discount the cash flows by a greater amount to get the same present value. Ergo, Z-Spread (the amount by which we must add to Treasury spot rates) will increase as the yield curve steepens. Does that make sense? Sorry if I’m confusing you more!
You really don’t want to get into the complicated math behind it. Just accept it:) I think the curriculum does mention this relation, but I don’t think it gets into the details.