The risk from market value changes
This is the difference between the cost of the debt and the risk free interest rate.
This is the risk which offsets the additional risk with a higher yield.
Credit spread risk is only exhibited when a mark-to-market accounting policy is applied.
Credit spreads are the most commonly used indicator of the risk-return profile of a bond.
There are a number of different types of credit spread:
Using Nominal Spread
Zero Volatility Spread
Using Zero Volatility Spread
The Z spread is the constant spread that makes the price of a security equal to the present value of its cash flows when added to each treasury spot rate.
Option Adjusted Spread
Using Option Adjusted Spread
If a security has embedded options we can use the "option adjusted spread".
There are 2 ways to derive the option adjusted spread:
1) binomial model - when the cash flows are not interest rate path dependent (for example, callable and puttable bonds)
2) monte carlo model - when the cash flows are interest rate path dependent (for example mortgage backed securities and home equity ABS)
Asset Swap Spread
Using Asset Swap Spread
In practice traders use the asset-swap spread and the z-spread as the main measures of relative value.
When the economy is expected to grow at a fast pace, spreads tend to tighten.
When the economy is expected to shrink at a slower pace, spreads widen.
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