The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• The traditional approach to bond valuation is to discount every cash flow using the same interest rate. The proper way is to value a bond using an arbitrage-free valuation model which involves viewing any bond as a package of zero-coupon bonds.

• To implement the arbitrage-free approach it is necessary to determine the theoretical rate that the U.S. Treasury would have to pay on a zero-coupon Treasury security for each maturity. The theoretical spot rates for Treasury securities represent the appropriate set of interest rates that should be used to value default-free cash flows.

• The Treasury spot rates can be used to value any default-free security. For a non-Treasury security, the theoretical value is not as easy to determine. The value of a non-Treasury security is found by discounting the cash flows by the Treasury spot rates plus a yield spread which reflects the additional risks.

• Nominal spread is the difference between the yield on a bond and the yield on a comparable maturity benchmark Treasury security. The nominal spread measure has two drawbacks which are overcome by the zero-volatility spread and the option-adjusted spread measures.

• The zero-volatility spread (Z-spread or static spread) is a measure of the spread that the investor would realize over the entire Treasury spot rate curve if the bond were held to maturity. The option-adjusted spread is the spread after adjusting for the value of the embedded option.

• Long-term spot rates are averages ...