So let's say we have a bond
the face value of Bond is thousand
coupon rate lets assume is 12%
let's a life of the bond is four years
so what will we do is step number one we will plot the cash of bond
1,2,3,4 so let me plot the cash
120 120 120 and 1120
so these are my cash
now what we would do is we would put down
Treasury spot rates
so ideally its a risky bond and risky bond should be dicounded with risky bond cashloss
risky band discount rate
but we're going to discount this with Treasury spot rates
let's assume that Treasury spot rate for year one
come out to be 10%
let's say this is 5% this was 6%
this was 6.5 percent
and let's say this was 7% these are
the different Treasury spot rates
what I am doing now
is that we would calculate discounted cash row
so discounted cash row 120 divided by 1+5% raise to one
discount first year cash log with 1
then take total followup them
then we got value of bond
by using this technique the value of the bond
came out to be 1175 but actually
this is a very high value because in the market the market the market prize of this bond
was only 975
the bond in the market was selling as a 975
the reason why we getting a value very high because we used Treasury spot rates
so what is that one rate that I add
to each of the Treasury spot rate
so that the value of the bond comes out to be exactly 975
so that rate is called Z - Spread
as of now I'm going to assume Z - Spread of 0%
just revise the formula
discounted cash flow is equal to
120 divided by one-plus
5 percent plus a constant
Z-Spread which as if now 0 then raise to 1
and now replicate the formula
but as of now the value would be zero
if I keep this number as 1% then it's coming out to be 1135 let's increase furder
if we keep this 3 we are going closer
5 even closer
6 very close so that means on average we are earning about 6 percent more
then the Treasure is spot rate cough
if you want to exactly how much we can use simple
goal seek function where we want this value
become how much 975 by changing what cell by changing
this cell and the correct answer is
5.99891% so this is your Z-Spread
and that this is the spread to you have to earning over and obove the Treasure is spot rates
cleared ... any Question to ask
so interpretation nominal spread and Z-Spread is correct
the only difference being the nominal spread was simply a difference between
right teams
which is nothing but mathematical average of spot mathematical
average of
rates for the risky bond
we're just finding out that one rate that is to be added to each of the
Treasury spot rates cough in such a way present value cash clause would be equal to
that
market prize of the bond and why are you giving Z-Spread 3 reasons again
one why do you get that extra spread
for taking three-risk one credit risk then
re-query risk and finally Option risk