Bootstrapping

Dr. Himanshu Joshi

What is Bootstrapping?
Par Rates:
One year par rate =5%, two year par rate = 5.97%, three year par rate
= 7.81%. From these we can bootstrap zero coupon rates.
One year zero coupon rate is the same as the one year par rate
because, under the assumption of annual coupons, it is effectively a
one year pure discount instrument.
However, the two year bond and later maturity bonds have coupon
payments before maturity and are distinct from zero coupon
instruments.
What is Bootstrapping?
The two year zero coupon rate is determined by solving the following
equation in terms of one monetary unit of current market value using
information the r(1) = 5%.
1 = 0.0597/(1.05) + 1.0597/(1+r2)2
in the equation, 0.0597 and 1.0597 represent payments from interest
and principal, respectively, per one unit of principal value.
What is Bootstrapping?
The three year zero-coupon rate can be bootstrapped by solving the
following equation, using the known values of the one year and two
year spot rates of 5% and 6%.
1 = 0.0691/(1.05) + 0.0691/(1.06)2 + 1.0691/(1+r3)3
Four year zero-coupon rate:
1 = 0.0781/1.05 + 0.0781/(1.06)2 + 0.0781/(1.07)3 + 1.0781/(1+r4)4