The Zspread, ZSPRD, Zerovolatility spread or Yield curve spread on a mortgagebacked security (MBS) is the parallel shift or spread over the zerocoupon Treasury yield curve required in discounting a predetermined cash flow schedule to arrive at its present market price. It is also widely used in the credit default swap (CDS) market as a measure of credit spread that is relatively insensitive to the particulars of specific bonds.
Since the Zspread uses the entire yield curve to value the individual cash flows of a bond, it provides a morerealistic valuation than an interpolated yield spread based on a single point of the curve, such as the bond's final maturity date or average life. However, the Zspread does not incorporate variability in cash flows, so a fuller valuation of a ratedependent security often requires the morerealistic (and morecomplicated) optionadjusted spread.
Definition
For mortgagebacked securities, a projected prepayment rate tends to be stated; for example, the PSA assumption for a particular Fannie Mae MBS might equate a particular group of mortgages to an 8year amortizing bond with 5% mortality per annum. This gives a single series of nominal cash flows, as if the MBS were a riskless bond. If these payments are discounted to net present value (NPV) with a riskless zerocoupon Treasury yield curve, the sum of their values will tend to overestimate the market price of the MBS. This difference arises because the MBS market price incorporates additional factors such as liquidity and credit risk and embedded option cost. The Zspread of a bond is the number of basis points (bp) that one needs to add to the Treasury yield curve (or technically to Treasury forward rates), so that the NPV of the bond cash flows (using the adjusted yield curve) equals the market price of the bond (including accrued interest). The spread is calculated iteratively.
Example
Assume that on 1/1/2008:

A bond has three future cash flows: $5 on 1/1/2009; $5 on 1/1/2010; $105 on 1/1/2011.

The corresponding zerocoupon Treasury rates (compounded semiannually) are: 4.5% on 1/1/2009; 4.7% on 1/1/2010; 5.0% on 1/1/2011.

The bond's accrued interest is 0.

The Zspread is 50 bp.
Then the price P of this bond on 1/1/2008 is given by:

\begin{align} P & = \frac{5}{(1 + \frac{4.5\% + 50\mathrm{bp}}{2})^{(2 \times 1)}} + \frac{5}{(1 + \frac{4.7\% + 50\mathrm{bp}}{2})^{(2 \times 2)}} + \frac{105}{(1 + \frac{5.0\% + 50\mathrm{bp}}{2})^{(2 \times 3)}} \\ & = 98.50, \\ \end{align}
where (for simplicity) the calculation has ignored the slight difference between parallel shifts of spot rates and forward rates.
Benchmark for CDS basis
The Zspread is widely used as the 'cash' benchmark for calculating the CDS basis. The CDS basis is commonly the CDS fee minus the Zspread for a cash bond of the same issuer and maturity. For instance, if a corporation's 10year CDS is trading at 199.7 bp and the Zspread for the corporation's 10year cash bond is 286.8 bp, then its 10year CDS basis is 87.1 bp.
See also
References

Frank J. Fabozzi, The Handbook of Fixed Income Securities, 7th edition; McGrawHill; 2005
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