Determining the Term Structure of Interest Rates through

Bootstrapping
Assume that coupon interest is paid annually and all bonds have a
face value of $100. Youre given the following yields to maturity
A. A one-year 13% coupon bond has a YTM of y = 10%
B. A two-year 11.5% coupon bond has a YTM of y = 9.5%
C. A three-year 9% coupon bond has a YTM of y = 9%
Compute
2
f
3
, i.e. the forward rate for a of a 1-year investment
starting in 2 years time.
In order to calculate the arbitrage-free value of
2
f
3
we need to gure out the
term structure of interest rates (or at least some relevant part thereof). We
can infer the term structure from the observed bond prices by bootstrapping,
i.e. through process of sequentially inferring spot rates from the prices of bonds
with increasing maturity. Recall that the yield to maturity of a bond is dened
as the constant discount rate that ensures that the sum of a bonds discounted
future cash ows equals its price:
P =
T

t=1
CF
t
(1 + y)
t
Also recall that the arbitrage-free price of a (risk-free) bond is the sum of the
bonds future cash ows discounted at the appropriate spot-rates, i.e. the spot-
rates that match the maturity of each cash ow:
P =
T

t=1
CF
t
(1 + y
t
)
t
Combining these equations, we get
T

t=1
CF
t
(1 + y)
t
=
T

t=1
CF
t
(1 + y
t
)
t
Solving these equations for bonds of dierent maturities will get us the term
structure of interest rates, which we can use to infer the arbitrage-free value of
2
f
3
. Lets start with the one-year bond:
1
CF
1
(1 + y)
=
CF
1
(1 + y
1
)
Since there is only one CF involved here, we can immediately see that y = y
1
=
10%. Lets move on to the two-year bond:
CF
1
(1 + y)
+
CF
2
(1 + y)
2
=
CF
1
(1 + y
1
)
+
CF
2
(1 + y
2
)
2
11.5
1.095
+
111.5
1.095
2
=
11.5
1.1
+
111.5
(1 + y
2
)
2
y
2
=

111.5

11.5
1.095
+
111.5
1.095
2

11.5
1.1

1 9.47%
We follow the same procedure to gure out the arbitrage-free value of y
3
:
CF
1
(1 + y)
+
CF
2
(1 + y)
2
+
CF
3
(1 + y)
3
=
CF
1
(1 + y
1
)
+
CF
2
(1 + y
2
)
2
+
CF
3
(1 + y
3
)
3
9
1.09
+
9
1.09
2
+
109
1.09
3

9
1.1
+
9
(1.0947)
2
+
109
(1 + y
3
)
3
y
3

109

9
1.09
+
9
1.09
2
+
109
1.09
3

9
1.1

9
1.0947
2

1/3
1 8.94%
Having inferred the relevant term-structure, we apply our usual replication ar-
gument to determine the arbitrage-free forward rate. That is, we note that a
one dollar investment between t = 2 and t = 3 at the relevant forward rate
2
f
3
would achieve a negative cash ow of one dollar at t = 2 (CF
2
= 1), and a
positive cash ow of that dollar plus interest rate at t = 3 [CF
3
= 1 (1 +
2
f
3
)].
We replicate CF
2
by borrowing
1
(1+y
2
)
2
for two years at the relevant spot-rate,
y
2
. We reinvest this money for three years at the appropriate spot-rate, y
3
,
achieving a cash ow at t = 3 of CF
3
=
(1+y
3
)
3
(1+y
2
)
2
. Since (in the absence of ar-
bitrage) this certain cash ow must be equal to the certain cash ow resulting
from the investment in the forward rate, we get the following equation:
1 +
2
f
3
=
(1 + y
3
)
3
(1 + y
2
)
2
2
2
f
3

(1.0894)
3
(1.0947)
2
1 7.88%
3