If the Yield Curve is Flat then the Nominal-Spread is equal to the Zero-Volatility-Spread. If the Bond is Option Free then the Zero-Volatility-Spread is equal to the Option-Adjusted-Spread. Don’t understand this… Please, could anyone elaborate as to what’s going on above? - Dinesh S
I just finished reading this section so I’ll give it a shot. The nominal spread is based upon the spread between a security and one point on the Treasury Yield Curve. One of the drawbacks is that b/c of this, it fails to take into consideration the term structure of spot rates. Thus, we have the Zero-Volatility Spread which DOES take treasury spot rates into account. However, if the yield curve is flat, then treasury spot rates are also flat. Therefore, both spreads should be equal. The Option Adjusted Spread was developed to incorporate the effect of interest rate volatility on bonds with embedded options, b/c the zero volatility spread does not do so (z-spread assumes interest rate volatility is zero). The Z-Spread=OAS + option cost. If the bond is option free, then Z-Spread = OAS. Hope this helps.
Mr_Clean, thanks for your clarification… Digging it further down, Nominal Spread = YTM (bond) - YTM (treasury) So if we have a corporate bond with YTM = 10% and a Treasury-Bond with YTM = 5%, Caeteris paribus!! Then we say that N.S. = 500 bp And I also understand that Z-Spread = O.A.S + cost of embedded-feature; which could be a call-option or a put-option So, If the bond is option-free then option-cost = 0, therefore Z-spread = O.A.S But I didn’t quiet get this sentence from you message… "One of the drawbacks is that b/c of this it fails to take into consideration the term structure of spot rates.” All this time in the book, they were talking of treasury-yields and YTM’s, so how did Spot-Rate yields come in all of a sudden?? Did I miss a page or something? We consider Spot-Rate-Yield only when we want to calculate the true-real-ideal-benchmark-price of the bond, since it’s a bad idea to discount the cash-flows from the bond coming at different time period with just a single discount rate (YTM), so spot rates are used to discount the each-specific cash-flow received at that specific period. - Dinesh S
What you’re saying is correct, I was just trying to convey that there is a difference between the treasury yield curve (which is used for nominal rates) and the treasury theoretical spot rate curve (which is used for spot rates), as seen on pg 579 of CFAI text. Perhaps just re-read section 4.2 from pages 574-587 and that should help clear things up.