Z-spread: The zero volatility spread (Z-spread) refers to the continuous spread that sets the cost of security equal to actual amount of cash flowing combined with the yields at every spot along the spot rate Treasury curve in which cash flow is received. That is, every payment is discounted according to an appropriate Treasury spot rate, plus the Z-spread. The Z-spread is also referred to in the form of a static spread.
Formula and Calculation for the Zero-Volatility Spread
In order to calculate a Z spread, investors must calculate into consideration the Treasury spot rate for the relevant maturity, and adding the Z-spread rate, and then apply this rate combined for the rate of discount to determine the value for the bond. The formula for calculating Z-spread is as follows:
P=Current price of the bond plus any accrued interestCx=Bond coupon paymentrx=Spot rate at each maturityZ=Z-spreadn=Relevant time period
As an example, suppose the bond is being sold at $104.90. It will have three cash flows: a five-dollar payment in the next year, a payment of $5 two years later and the final payment total of $105 over the course of three years. In addition, the Treasury interest rate for the spot at one, two and three-year dates are 2.5 percentage, 2.7% and 3 3.0%. The formula could be as follows:
When you’ve got the right Z-spread, this is a simple process to:
This indicates that the Z-spread will be 0.25 percent in this instance.
What the Zero-Volatility Spread (Z-spread) Can Tell You
A Z-spread calculation differs from the calculation of a nominal spread. Nominal spread calculations employs only one point in the Treasury yield curve (not the spot-rate Treasury yield curve) to calculate the spread at one spot that is equal to the value at present that the securities’ cash flows in relation to the price.
The zero-volatility spread (Z-spread) assists analysts in determining whether there’s a difference in the price of a bond. Because the Z-spread measure the spread that investors will get over the whole of the Treasury yield curve, it provides analysts with an accurate assessment of a security rather than one-point metrics, for example, the bond’s date of maturity.
