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Definition: Zero-Volatility Spread (Z-Spread)
Zero volatility spread is also known as yield curve spread. Z spread is a useful tool to price a bond. A bond’s yield is the interest paid annually divided by its purchasing price. As Treasury bond’s interest rates are risk free interest rates, all other bonds will yield more than Treasury bond does. So when the yields of different maturity periods are plotted on the graph we get yield curve. When two yield curves are compared we get yield spread.
So the z spread is the amount of yield received from a non-treasury bond over and above the Treasury bond having the same maturity period as a non-treasury bond has. Finding the z spread requires to calculate present value of the cash flows from a non-treasury bond and this present value of non-treasury bond’s cash flows determine the price of that bond.