Really struggling with Option Adjusted Spreads and Zero volatility Spreads. If anyone could simplify these definitions and there use that would be great.
Please and thank you
Agreed
I need to finish my article on OAS and Z-spreads. One of these days.
The Z-spread (you’re correct: it means zero-volatility spread) is the spread added to each rate on the (Treasury) spot curve so that the price of the subject bond (discounted at spot-plus-spread rates) equals the market price. The Z-spread represents the additional yield received for all risks on the bond above those on risk-free (Treasury) bonds.
The OAS is the spread added to each in a (Treasury) binomial tree – these are forward rates, not spot rates – so that the price of the subject bond (discounted at forward-plus-spread) rates equals the market price. Because the binomial tree explicitly accounts for the value of any embedded options, the OAS is the additional yield received for all risks on the bond _ except option risk _ above those on risk-free (Treasury) bonds. That is, the OAS is the spread corresponding the the equivalent option-free bond (i.e., the bond that has all of the risks of the subject bond, but with no embedded options).
I think one of the main take away points with the Z-spread is that it takes into account the yield curve. The nominal spread does not. If the nominal spread = the z-spread then the yield curve is flat. If z-spread is greater than the nominal, the yield curve is positive.
That’s correct: the nominal spread is added to _ one _ point on the _ par curve _, while the z-spread is added to _ every _ point on the _ spot curve _.
S2000magician, if one day i am even half as smart as you i will be happy with my life.
Thank you (and KmeriwetherD) for the explanation!
You’re very kind.
I’m glad to help.