I have basically memorized the fact that when the following two situations occur, z-spread has the greatest divergence from nominal spread: 1) steeper the curve, greater the divergence 2) earlier bond principal is paid, greater the divergence Can someone explain why this is the case? I just understand things much better when someone explains the concepts. Thanks
Had posted this a few days back: Nominal Spread as you said measures the spread at just 1 point in time (for just 1 maturity, say, 5 years) whereas Z-Spread measures a static spread added over the ENTIRE yield curve (for all maturities, say from year 1 to year 5). Now, lets compare a 5 year Zero Coupon Bond and a 5 year MBS. Assume the yield curve to be normal and discount rates are 3,4,5,6 & 7% for each year 1,2,3,4,5 respectively. A 5 year Zero Coupon Bond will be valued by discounting the par value (at the end of 5 years) by 7% (discount rate at year 5). Since just 1 discount rate is used, the value under both Nominal Spread & Z-Spread will not differ significantly. An MBS on the other hand will be valued by using 5 different rates (3,4,5,6 & 7% ; assuming 5 cash flows) under Z-Spread and just ONE rate under nominal spread (each of the cash flows will be discounted by 7%). Thus the difference in value will be much larger. The example isn’t complete but illustrates the concept. 
link: http://www.analystforum.com/phorums/read.php?11,1156700,1156788#msg-1156788
smileyface Wrote: ------------------------------------------------------- > Had posted this a few days back: > > > Nominal Spread as you said measures the spread at > just 1 point in time (for just 1 maturity, say, 5 > years) whereas Z-Spread measures a static spread > added over the ENTIRE yield curve (for all > maturities, say from year 1 to year 5). > > Now, lets compare a 5 year Zero Coupon Bond and a > 5 year MBS. Assume the yield curve to be normal > and discount rates are 3,4,5,6 & 7% for each year > 1,2,3,4,5 respectively. > > A 5 year Zero Coupon Bond will be valued by > discounting the par value (at the end of 5 years) > by 7% (discount rate at year 5). Since just 1 > discount rate is used, the value under both > Nominal Spread & Z-Spread will not differ > significantly. > > > An MBS on the other hand will be valued by using 5 > different rates (3,4,5,6 & 7% ; assuming 5 cash > flows) under Z-Spread and just ONE rate under > nominal spread (each of the cash flows will be > discounted by 7%). Thus the difference in value > will be much larger. > > > The example isn’t complete but illustrates the > concept. > > > link: > http://www.analystforum.com/phorums/read.php?11,11 > 56700,1156788#msg-1156788 Great Post but i think this is the correct statement is the ENTIRE theoretical Treasury spot rate curve ! "whereas Z-Spread measures a static spread > added over the ENTIRE yield curve think "
thanks for pointing that out… Z spread - Treasury spot rate curve Nominal spread - 1 point on Treasury yield curve Who knows even this might turn into a question from CFAI!!
Page 479 in the CFA book summarizes it pretty well.