Just got hung up on a sentence about Z-spread. Hope someone can help!
" if we ignore the embedded options for a bond and estimated the Z-spread, the estimated Z-spread will include the cost of the embedded option (option risk as well as compensation for credit and liquidity risk)."
If we ignore the embedeed option already, why would Z-spread inlcude the cost of the embedded option?
Thanks!
As usual, their language is . . . well . . . rotten.
When we use a binomial tree to compute, say, the OAS of a callable or putable bond, we explicitly include the effect of the embedded option in the tree. In this way, we eliminate the value of the option, because we have included it (explicitly) in the tree, and the market price includes it (implicitly). It’s on both sides of the equation, so its effect is eliminated.
When we compute a z-spread, we do not explicitly include the effect of the embedded option in the spot curve; we – to use their word – _ ignore _ it. Therefore, we have a price that includes the effect of the option (implicitly), but a spread that does not; therefore, the effect of the option is still there (i.e., is included in the spread).
Sigh.
Thanks for your detailed replies! Great to know. I think people would like you to wirte a exam prep book. Have a good night!
My pleasure.
I get really annoyed that others cannot figure out how to explain this stuff clearly.
(Then again, I’d be out of a job.)