We use spot rates to get an arbitrage-free value for govt bonds (risk- free bonds). But, why do we use the same spot rates to value corporate bonds which carry credit risk ? Shouldn’t we use higher rates?
We don’t.
We do.
Perhaps you’ve heard of the z-spread?
We use the govt. spot rates, but add a spread called Z-spread, and you can adjust the bond values at each node for a bond with an embedded option and calculate the OAS (which excludes the spread for the option).
Got it. Thanks
My pleasure.