What is the 'Zero-Volatility Spread - Z-spread'
The Zero-volatility spread (Z-spread) is the constant spread that makes the price of a security equal to the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where a cash flow is received. In other words, each cash flow is discounted at the appropriate Treasury spot rate plus the Z-spread. The Z-spread is also known as a static spread.
Explaining 'Zero-Volatility Spread - Z-spread'
The Z-spread helps analysts discover if there is a discrepancy in a bond's price. Because the Z-spread measures the spread that an investor will receive over the entirety of the Treasury yield curve, it gives analysts a more realistic valuation of a security instead of a single-point metric, such as a bond's maturity date.
A Z-spread calculation is different than a nominal spread calculation. A nominal spread calculation uses one point on the Treasury yield curve (not the spot-rate Treasury yield curve) to determine the spread at a single point that will equal the present value of the security's cash flows to its price.
Q&A About Zero-Spread Volatility
How does one calculate the Z-spread?
One calculates it by using the entire yield curve to value an individual cash flow. This can be done by discounting each cash flow at its appropriate spot rate and then calculating their present values. Then, one can use these present values to find out how much they are worth today. Finally, one subtracts this amount from the initial price of that bond and divides it by that bond's maturity value (the difference between its final payment and its initial payment). This gives you your answer in percentage form.
What is the Z-spread?
The Z-spread is a measure of the spread over the yield curve required to value an individual cash flow.
How does one use this derivative instrument?
One would use it by trading it on an exchange; however, they must have enough money to cover their positions if they were forced to close them out at any time during trading hours.
What determines the price of these derivatives?
The price depends upon how volatile markets are at any given time period when compared to historical averages over various periods of time (e.g., daily, weekly, monthly). If markets become more volatile than usual then investors will pay more for these types of derivatives because they want protection from unexpected changes in stock prices or commodity prices due to increased uncertainty about future performance expectations (i.e., earnings per share growth rates) as well as economic conditions (i.e., GDP growth rates). On the other hand, if markets become less volatile than usual then investors will pay less for these types of derivatives because they do not feel as though they need protection
What does "Z" stand for in "Z-Spread"?
Zero since it represents a zero coupon bond with no coupons or interest payments due on it until maturity. Thus, there are no spreads or differences between any of its cash flows because they all occur at once when the bond matures.
What does Zero Spread mean?
It means that there is no initial cost to buy or sell this derivative instrument.
What are some examples of underlying assets for these derivatives?
Equity and commodities are two examples of underlying assets for these types of derivatives instruments.