Bootstrapping is a method for constructing a zero-coupon yield curve from the prices of a set of coupon-bearing products.As you may know Treasury bills offered by the government are not available for every time period hence the bootstrapping method is used mainly to fill in the missing figures in order to derive the yield curve. The bootstrapping method uses interpolation to determine the yields for Treasury zero-coupon securities with various maturities.
We have bonds/instruments with face value of $100 with maturity of 6months, 1 year, 1.5 years and 2 years. Let’s assume for simplicity that coupon for those individual bonds equal to YTM on those bonds implying that Bonds are trading at Par. i.e. $100
As you can see for 6-month security we are going to receive only single bullet payment implying that its yield is equivalent to zero coupon bonds. Hence we can say 6 months Spot rate is 3%. Now if we consider 1 year security you can see that we are going to receive two cashflows, first one after 6 months (of $2) and another at the end of a year (of $102 = principal + coupon). Discounting this cashflow @ 4% will give us its market price of $100 however we know that first cashflow should be discounted at 3% as that is the spot rate for that tenor. So the question becomes at what rate we should discount next cashflow which we are going to get at the end of year 1 so that price comes to $100?
We can get this answer by solving simple equation:
Solving for 'X' gives us value if 4.01%. This rate is effectively zero coupon rate for 1 year security and we will call it 1 year Spot rate. Now similarly we can continue this process for maturity of 1.5 year, 2 years & so on...
The formula, however to calculate next spot rate can be simplified as
You can also watch the youtube video for more theoretical explanation.
Talk to our expert career counselors who can guide you about CFA exam, career opportunities and preparation!
The attached excel file provides you with complete reconciliation and explanation on how to bootstrap.
Global Association of Risk Professionals, Inc. (GARP®) does not endorse, promote, review or warrant the accuracy of the products or services offered by EduPristine for FRM® related information, nor does it endorse any pass rates claimed by the provider. Further, GARP® is not responsible for any fees or costs paid by the user to EduPristine nor is GARP® responsible for any fees or costs of any person or entity providing any services to EduPristine Study Program. FRM®, GARP® and Global Association of Risk Professionals®, are trademarks owned by the Global Association of Risk Professionals, Inc
CFA® Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by EduPristine. CFA® Institute, CFA® Program, CFA® Institute Investment Foundations™ and Chartered Financial Analyst® are trademarks owned by CFA® Institute.
Utmost care has been taken to ensure that there is no copyright violation or infringement in any of our content. Still, in case you feel that there is any copyright violation of any kind please send a mail to email@example.com and we will rectify it.
2017 © Edupristine. ALL Rights Reserved.