Why Discount Margin Is Used for Floating-Rate Bonds

Summary

The document asks how Z-spread and discount margin differ when valuing fixed-rate and floating-rate bonds. It describes Z-spread as a parallel shift applied to the zero-rate curve and notes the common association of Z-spread with fixed-rate notes and discount margin with floating-rate notes.

The answer gives a practical reason for using discount margin with a floater: calculating a Z-spread requires knowing the bond’s cash flows, while future floating coupon cash flows are not fixed in advance. Discount margin can instead be calculated using an assumption about those future cash flows. The discussion is brief and does not derive either measure, specify a cash-flow forecasting method, or resolve the question about combining current zero rates for discounting with forward rates for projecting coupons. Its explanation is therefore limited to the cash-flow uncertainty behind the choice of spread measure.

Key ideas

• A Z-spread is described as a parallel shift to the current zero-rate curve.
• Calculating a Z-spread for a floating-rate bond requires a view of its future cash flows.
• Discount margin is used for floaters when future cash flows are assumed rather than known.
• The explanation does not specify how to forecast floater coupons or settle the curve-selection question.

Tags

# Z-Spread vs Discount Margin


# Z-Spread vs Discount Margin












I'm comparing two types of discounting: Z-Spread and Discount Margin.

Reading the article by O'Kane Credit Spread Explained I found Z-Spread is used for fixed rate notes meanwhile Discount Margin, and Z-DM, are used for floating rate notes.

I got the two definitions:

- Z-Spread: vertical parallel shift over the current zero rate curves



My question is: why theoretically speaking is more correct to use Discount Margin for floating rate notes meanwhile I should use Z-Spread for fixed rate ones?

For floating rate notes, is it also correct to use the current zero rate curve for discounting and the forward curve for generating future cashflows?

## Answer by Harry Lijia Qin (score 1)

https://quant.stackexchange.com/a/35371

For floating-rate bonds, it is difficult to compute z-spread if you don't know their cash flows. As a result, you would use discount margin where you have an assumption for the future cash flows of the floater.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.