I was looking at the Schweser notes pg 115, where they talk about the 2 primary factors that influence the difference between the nominal spread and the zero-volatility spread.
I don’t really understand why the difference between the 2 spread measures will be greater if the spot yield curve is upward sloping. Isn’t the Z-spread a fixed number added to the spot rates, which then tells us the YTM? If so, shouldn’t the Z-spread = nominal spread at all times?
I’m not sure what I missed…any help would be appreciated.
The Z-spread is indeed a fixed number of points added to the spot rates and it is equal to the nominal spread if the yield curve is flat.
If the yield curve is upward sloping, for instance 1-year, 2-year, 5-year rates are 2%, 4% and 6% respectively and you compare it to a flat yield cuve of 6%, then a bigger spread needs to be applied to the upward sloping curve in order to discount payments more heavily. Otherwise the prices of the bonds derived from the two spot rates will not be equal.