The zero-volatility spread will tend to diverge from the nominal spread by greater amounts, the: a. Flatter the yield curve. b. Shorter the bond’s maturity. c. Higher the bond’s coupon. d. Slower the bond’s principal prepayment rate. - Dinesh S
C? a. nominal and z spread are the same for flat yield curves b. diverge by less c. higher coupons are more likely to repay principal (could someone explain this further? this concept doesn’t seem to hit home yet) d. not sure
the difference i remember from the two is that Z is based on spot rates whereas nominal is based on YTM. based on that i would say C.
C looks like the one. Z-Spread is equal amt that must be added to each spot rate to correctly price the bond Higher coupons imply higher reinvestment risk (i.e. I need to reinvest a larger amount of coupon payments at the YTM in order to achieve the YTM). As such, the Treasury spot rates are lower than those appropriate for these risky securities, so discounting a bond at T-spot rates will prob overestimate the bond value; so the nominal spread will be inflated. The Z-Spread will add to each spot rate until the ‘correct’ price is achieved. This means Nominal-ZSpread will be bigger. The other choices mean that the difference in Z-Spread and Nominal Spread is smaller because there are lower risks on bonds that are short-dated, have low repayment risk, or trade in a flat yield curve environment. Therefore the bond will have a flatter spot discount rate profile, so Nominal Spread and Z-Spread will be closer.
what dies d mean?
D is about amortizing bonds. With a standard issue coupon bond all the principal is paid back at maturity which is a pretty slow prepayment rate. With an amortizing bond (e.g., a mortgage) principal is paid back on some schedule until maturity.
thakns how does that realte to z spread? will that in a way be closer to the z spread as opposed to a high coupon bond
It’s just the other side of HakMat’s answer above. In an amortizing bond, the slower the principal repayment rate, the closer the Z-spread and nominal spread.
So it be correct to say that the more Reinvestment Risk (e.g. Longer Maturity and/or Higher Coupons) the more divergent the Z and Nominal Spreads will be?
Mostly - although it makes no difference if the yield curve is flat.