Nominal vs. Z-Spread vs. OAS

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thisisbrianly

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Hey guys,
I’m having a bit of trouble understanding the difference btw the three spread measures. What I think I understand so far:
- Nominal spread is simply the “YTM on the bond - YTM on treasury”
- Z-spread is the constant spread above spot-rate curve that discounts bond payments to price
- OAS is similar to z-spread (uses spot rate curve) but also carves adjusts for option price
What I don’t quite understand is what the difference between the Yield Curve (benchmark for nominal spread) and Spot Curve (benchmark for Z-spread).
Isn’t the Yield Curve equal to observed yields on zero coupon bonds at different maturities, and if thats the case, wouldn’t that be the same as the Spot Curve? Or does the Yield Curve take into account coupon payments somehow?
Any insight is appreciated, thanks!
 
yield curve is based on the yield to maturity on treasuries ie you apply the same discount rate to all the cashflows (the YTM) across the whole life of the bond. whereas spot rate curve treats each period differently – making it like a series of zero coupon bonds with different maturies. Cheers
 
In addition to what Kiakaha said above, what I understand is that YTM is the yield for a bond with cashflows that you get by discounting all intermittent cashflows and par value you receive at maturity. Spot Rate Curve is a curve of rates that are applicable when the bonds have no coupons i.e. you don’t have to worry about re-investment risk.
If I have 2 cashflows next year and I calculate YTM, it is the yield I receive if I re-invest the first cashflow back at YTM. It is like IRR.
But spot rate is the discount rate for 6 month cashflow and a different discount rate for 1 yr cashflow giving me the present value (price) of the bond. You don’t have to worry about re-investing the 6 month cashflow.
 
Cool, thanks guys. That makes sense….YTM is IRR, spot rate adjusts per coupon.
 
can anybody explain more about option cost ? and drawbacks of each spread.
In Book, they say:
Option cost= Z spread - OAS.
In the case of callable bond. Z > OAS then Option cost is positive. the explaination is because of uncertain cash flows and option is granted to issuer.
If bond is putable, we’ll have negative option cost, (Z
 
vnnvnn Wrote:
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> can anybody explain more about option cost ? and
> drawbacks of each spread.
>
> In Book, they say:
>
> Option cost= Z spread - OAS.
>
> In the case of callable bond. Z > OAS then Option
> cost is positive. the explaination is because of
> uncertain cash flows and option is granted to
> issuer.
>
> If bond is putable, we’ll have negative option
> cost, (Z buyer.
>
> and please talk more about drawbacks of each
> spread.
>
> Thank you.
What I understand. Correct me if I am wrong:
Option cost is just the cost of an option (call or put) in terms of yield. If a bond has a call option, it will be giving a higher yield due to the risk of being called. Since
Z Spread = OAS (Option Adjusted Spread) + Option Cost
OAS does not account for the yield needed for that particular option in the bond. Option cost accounts for it.
Hence option cost is positive for callable bond (total higher yield given) and negative for putable bond (in this case, the yield will be lower than the yield of a straight bond)
This is in contrast to the price of a callable bond (which is lower than the price of a straight bond) and the price of a putable bond (which is higher than the price of a straight bond)
 
it is clear now. Thank anish,
refer to option cost in measure of interest rate. call option is more valuable when yield is low, less valuable when yield is high.
I also understand about shortcomings of each spread, especially nominal and Z spread, just about: 1) term structure of interest 2) characteristics of bond
 
vnnvnn Wrote:
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> I also understand about shortcomings of each
> spread, especially nominal and Z spread, just
> about: 1) term structure of interest 2)
> characteristics of bond
Quick question about this….wouldn’t the Z spread already take into account the term structure of interest rates? Since it is the static spread above each spot yield (which changes across the term/maturity)?
 
To be honest, I don’t understand the question. This is what I understand about spreads:
The spot rate curve is made from treasury yield curve. Spot rate curve is more accurate measure of yield because it doesn’t assume that cash is reinvested at the same rate. Spot rate is the different rate applicable on each cashflow as and when it arrives.
Spread is what you get additionally for taking liquidity, credit and embedded option risk (since you are taking non-treasury bonds)
Nominal spread is the spread you get above the treasury yield (for a particular yield hence it is at a point)
Z spread is the spread you get above the spot rate curve (and is hence more realistic)
OAS is the Z spread adjusted for option so it measure only the additional credit and liquidity risk.
As for:
“refer to option cost in measure of interest rate. call option is more valuable when yield is low, less valuable when yield is high.”
I think when you say call option is more valuable when yield is low, you mean it is priced higher (i.e. bond price is lower) when yield is low because the bond can be called.. when yield is low, the issuer could call the bond and issue a new bond at lower cost. not sure though…
“I also understand about shortcomings of each spread, especially nominal and Z spread, just about: 1) term structure of interest 2) characteristics of bond”
Is there a question here… I am really confused
“wouldn’t the Z spread already take into account the term structure of interest rates? Since it is the static spread above each spot yield (which changes across the term/maturity)”
I would say nominal spread does not take interest rate structure into account since it is only on one point. The cashflows could alter and give a different yield (say if the bond is called). On the other hand, Z spread does since it is over the entire spot rate curve (that is why it is called zero volatility spread)
 
Hi anish,
“I think when you say call option is more valuable when yield is low, you mean it is priced higher (i.e. bond price is lower) when yield is low because the bond can be called.. when yield is low, the issuer could call the bond and issue a new bond at lower cost”.
This is what i mean anish, just my discussion about embeeded option in the reading of measure of interest rate risk.
“I also understand about shortcomings of each spread, especially nominal and Z spread, just about: 1) term structure of interest 2) characteristics of bond”
Is there a question here… I am really confused
this was my previous question, about divergence between Z- spread and Nominal spread. I agree with your answer
“I would say nominal spread does not take interest rate structure into account since it is only on one point. The cashflows could alter and give a different yield (say if the bond is called). On the other hand, Z spread does since it is over the entire spot rate curve (that is why it is called zero volatility spread)
also what i understanded from page 563, book 5 curriculum.
Thanks, you seem to understand all anish.
 
vnnvnn Wrote:
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> Thanks, you seem to understand all anish.
That, we will know in July! (and a little bit tomorrow when I take the Elan mock!)
 
anish Wrote:
——————————————————-
> vnnvnn Wrote:
> ————————————————–
> —–
>
> > Thanks, you seem to understand all anish.
>
> That, we will know in July! (and a little bit
> tomorrow when I take the Elan mock!)
anish, just curious what your study strategy is for the next month. You seem to be pretty far along and taking mocks and all. Whats your plan for the next 6 weeks til the test?
 
thisisbrianly Wrote:
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>
> anish, just curious what your study strategy is
> for the next month. You seem to be pretty far
> along and taking mocks and all. Whats your plan
> for the next 6 weeks til the test?
I will get back on this in a day or two after I take the mock. Will plan according to the result. Though my general idea is a mock a week and a thorough revision of all ‘theory’ e.g. ethics, corp gov, red flags of FRA etc. Plus, CFA book EOC questions (I had marked the tough ones while doing them the first time around so there are on an average 3-4 in each reading) and I have marked the tough questions of Elan practice questions too for another look. Last week, I plan to sleep and revise the formulas!
 
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