FBS turns 16
Usually, debt instruments with different characteristics (maturity date/credit rating or risk) have different yields. To understand better what is spread, let’s take bond yields as an example and analyze the risks related to them. The bond yield is the return rate, which holders of bonds get if they have this bond until maturity and receive the cash flows at the promised dates. Risks include credit, interest rates, inflation, and others.
We can divide the measures of yield spread into the nominal spread (G-spread), interpolated spread (I-spread), zero-volatility spread (Z-spread), and option-adjusted spread (OAS).
Nominal spread (G-spread) represents the difference between Treasury bond yields and corporate bond yields with the same maturity. Treasury bonds have zero default risk, which is why the difference between corporate and Treasury bonds shows the default risk. We can calculate the G-spread by using the following formula:
G-Spread = corporate bond’s yield – government bond’s yield
Interpolated spread (I-spread) is the difference between a bond’s yield and the swap rate. We can use LIBOR as an example. It shows the difference between a bond’s yield and a benchmark curve. If the I-spread increases, the credit risk also rises. I-spread is usually lower than the G-spread.
This type of spread is also known as a zero-volatility spread. Z-spread is added to each spot interest rate to make the present value of the bond’s cash flows equal to the bond’s price.
The option-adjusted spread is calculated as a zero-volatility spread minus the call option’s value. There is a term “spread” in the Forex market, too. It refers to the commission you pay a broker. The Forex spread is calculated as a difference between the bid and ask prices.