Chartered Financial Analyst (CFA) Practice Exam Level 2

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How is the Z-Spread calculated?

  1. It is the current market yield of a bond minus its par value

  2. Implied Spot Curve yield plus a spread adjustment

  3. Average interest rates across different maturities

  4. The difference between the expected and actual bond returns

The correct answer is: Implied Spot Curve yield plus a spread adjustment

The Z-Spread is calculated by taking the yields from the bond's cash flows and adjusting them to account for the implied spot yield curve. This involves determining the yield that would make the present value of the bond's cash flows equal to the market price of the bond, effectively allowing the yield to be adjusted based on market conditions and the risks associated with the bond. In this context, "Implied Spot Curve yield plus a spread adjustment" refers to the process of establishing a baseline yield from the spot yield curve and then adding a spread that reflects the specific bond's risks, such as credit risk, liquidity risk, or other risk factors that might not be fully captured by the spot yield alone. This spread adjustment helps investors understand the relative value of the bond compared to risk-free securities and assess its yield in comparison to other investment opportunities. This calculation is crucial for fixed income investors as it provides insights into the risk premium associated with a bond and serves to evaluate its attractiveness relative to other securities in the market. By utilizing the spot yield curve, the Z-Spread can reflect changes in market dynamics and the risk profile of bonds more accurately than simply looking at nominal yields.

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