Risk-free benchmark

The forward credit spread can be determined by considering the spot prices for the risky security and risk-free benchmark security, while the... 

The historical volatility of the difference between the reference asset yield and the yield on a risk-free benchmark. 

The general rule of corporate bonds is that they are priced at a spread to the government yield curve. In absolute terms, the yield spread is the difference between the yield to maturity of a corporate bond and the benchmark, generally a yield to maturity of a govermnent bond with the same maturity. Corporate bonds include a yield spread on a risk-free rate in order to compensate two main factors, liquidity premium and credit spread. The yield of a corporate bond can be assumed as the sum of parts of the elements as shown in Figure 8.1, in which the yield spread relative to a default-free bond is given by the sum of default premium (credit spread) and liquidity premium. 

Thus OAS is a general stochastic model, with discount rates derived from the standard benchmark term structure of interest rates. This is an advantage over more traditional methods in which a single discount rate is used. The calculated spread is a spread over risk-free forward rates, accounting for both interest-rate uncertainty and the price of default risk. As with any methodol-ogy, OAS has both strengths and weaknesses however, it provides more realistic analysis than the traditional yield-to-maturity approach. Hence, it has been widely adopted by investots since its introduction in the late 1980s. 

Free allocations to new entrants entails a serious risk of competition distortions between Member States. Moreover, free allocations to new entrants can lead to loss of environmental integrity as it may affect choice of technologies. If free allocations to new entrants are maintained, ex-ante benchmarking should be preferred. 

A Z-spread can be calculated relative to any benchmark spot rate curve in the same manner. The question arises what does the Z-spread mean when the benchmark is not the euro benchmark spot rate curve (i.e., default-free spot rate curve) This is especially true in Europe where swaps curves are commonly used as a benchmark for pricing. When the government spot rate curve is the benchmark, we indicated that the Z-spread for nongovernment issues captured credit risk, liquidity risk, and any option risks. When the benchmark is the spot rate curve for the issuer, for example, the Z-spread reflects the spread attributable to the issue s liquidity risk and any option risks. Accordingly, when a Z-spread is cited, it must be cited relative to some benchmark spot rate curve. This is essential because it indicates the credit and sector risks that are being considered when the Z-spread is calculated. Vendors of analytical systems such Bloomberg commonly allow the user to select a benchmark. 

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