Z-spread is a tool used by investors to measure the spread captured over the yield curve if a security is held to maturity. It can also be used as an economic indicator, with a negative Z-spread indicating an impending recession. Calculating the Z-spread requires trial and error to find the correct spread, using basis points. It is not limited to any one spot rate curve and can be used to measure the credit, liquidity, and option risks of a non-treasury guarantee.
A z-spread, or zero volatility spread, is the spread where the security’s discounted cash flows equal its present value on a spot yield curve. Its primary purpose for investors or traders is to measure the spread that can be captured over the yield curve if the security is held to maturity. It is a useful tool for analyzing a non-treasury guarantee, as it measures its credit, liquidity and option risks. Z-spreads can also be used as an economic indicator, where a negative Z-spread often indicates that a recession is on the way. Calculating the z-spread requires trial and error to find the correct spread, using basis points so that the present value of the cash flows and the price of the bond are the same.
The z-spread calculation begins with adding basis points to each rate on the point curve. For example, if the two-year rate on the spot curve is 4% with 50 basis points to add, the rate would be 4.50%. An analyst can use this rate to calculate the present value of each cash flow and then add all the cash flows together. The grand total of the cash flows must equal the price of the security. If these two numbers do not match, recalculations will need to be made using different spreads, or basis points, until the present value of the cash flows is the same as the price of the bond.
The advantages of a z-spread include its ability to be independent of other points on the performance curve. Unlike the nominal spread, the z-spread does not depend on a single point on the yield curve, allowing investors or traders to rely on it. While z spreads are most commonly used by investors and traders, they are sometimes used as an indicator of the health of the economy. For example, a negative z-spread may point to an impending recession.
The z-spread measure is not limited to any one spot rate curve, so the calculations should clearly indicate which spot rate curve was used. For example, a z-spread may use the security issuer’s spot interest rate curve to measure the liquidity and option risk of this particular instrument. Highly rated, short-term debt will have little or no difference between the z-spread and the asset swap spread. If there is a difference between these two spreads for this type of debt, then it can be safe to assume that the market has not priced this security accurately and adjustments will follow shortly.
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