The nominal spread has an additional weakness in that it compares the yield on assets with various patterns of monthly principal and interest cash flows (i.e., MBS) to the yields on a Treasury security (or securities, if the interpolated yield is used) paying semiannual interest with a bullet payment at maturity. A more accurate measure of spread is to compare an MBS to a portfolio of Treasury securities having the same cash flows. This spread is called the zero-volatility spread. While it does not take prepayment risk into account, it does account for the various patterns that principal payments on an MBS or CMO can take at a given prepayment speed.
The zero-volatility spread or Z-spread is a measure of the spread that the investor would realize over the entire Treasury spot rate curve if the mortgage security is held to maturity. It is not a spread off one point on the Treasury yield curve, as is the nominal spread. Rather, it is the spread that will make the present value of the cash flows from the MBS equal to the price of the MBS when discounted at the Treasury spot rate plus the spread. An iterative process is used to determine the zero-volatility spread.
In general, the shorter the average life of the MBS, the less the zero-volatility spread will differ from the nominal spread. The magnitude of the difference between the nominal spread and the zero-volatility spread also depends on the shape of the yield curve; the steeper the yield curve, the ...