the explanation in the CFAI text is less than straighrforward. can someone summarize the main differences between the three spreads and comment on how this may be tested?
Nominal Spread: Target security YTM - Benchmark YTM Z-Spread: Target Rate - Spot Rate OAS: Z-Spread + - Embedded Option Cost (in %) -For callable bonds: Embedded Option Cost > 0 -For puttable bonds: Embedded Option Cost < 0 OAS reflects spread for credit risk & liquidity risk.
You gotta know this stuff - read more until you have it. This is especially important as it is a basis for lots of LII stuff.
i am having trouble with defining z-spread… what does it mean by “target rate - spot rate”? and what is the (if there are any) relationship between nominal and Z spreads? i remember schweser said something about z-spread being the difference between the rate of riskier bond spot and rate of treasury bond, or something to that extent, but i didn’t really get it.
have a look into your books: the nominal spread is defined as the spread in yields. the z-spread is defined as being the spread on the *whole yield curve*.
I thought the z/ytm difference was more like: ytm assumes a flat yield curve (so all flows are discounted at the same rate); z spread approach relaxes that assumption, allowing a term structure of rates. (However, only the benchmark rate can exhibit a TS; the spread itself is the same everywhere.)