Bootstrapping Lecture – Session 6

In the financial markets, at any given time, there are several types of interest
rate curves:

The Observable Curves

 Government Treasury Yield Curve (YTM) – Repos, T-Bills, PIBs
 Corporate Bond Yield Curves - TFCs
 Libor/Kibor Curves – Contributed by FIs and averaged by Reuters
 Interest Rate Swap Curves – Posted by ADDs on their websites

The Implied Curves

 The Par Curve – a string of yields that are required for bonds of different
maturities to be valued at Par
 The Spot Curve or Zero Curve – the curve that constitutes those unique
rates which are applicable to each bond cash in order for the sum of
cash flows to equate to the market price
 The Forward Curve – forward starting strips of yields for any maturity,
say 3 months, 6 months or 1 year and so on.

For these implied curves to be derived and to be comparable, it is a prerequisite

that the same class or category on instruments are considered such as only
Government bonds or Corporate bonds of one particular issuer etc.

Bootstrapping – Deriving a Zero Curve from a Par Curve

Let us take a simple example:

We consider a series of bonds in the same asset class, say government bonds,
each with a par value of 1000 but with different coupons in different maturities.
 The Par Yield is the yield at which, when the bond cash flows are
discounted, they value the bond at par.
 The zero curve needs to be derived from the par curve as below:
Maturity Par Yield Zero Curve

0.5 7.00% 7.00%  A rate without any interim payments is a

1 8.80% 8.8400% zero rate
1.5 9.20% 9.2468%  Since these par rates have interim coupon
2 9.50% 9.5586% payments, their corresponding zero rates
2.5 9.75% 9.8241% have to be calculated.
3 10.00% 10.0973%

 The 6m Spot or Zero Rate is easy as it is simply the par yield having no
interim payments.
 We can compute the 1 year zero rate as follows:

1000 = (1000*0.088/2) / (1+0.07/2) + 1000*(1+0.088/2) / (1+ S2/2) ^2

1000 = 42.51 + 1044 / (1+ S2/2) ^2

1000 – 42.51 = 1044 / (1+ S2/2) ^2

957.49 = 1044 / (1+ S2/2) ^2

(1+ S2/2) ^2 = 1044 / 957.49 = 1.0904

1 + S2/2 = SQRT (1.0904)

S2 = (1.0442 – 1)* 2

S2 = 8.84 %

We can similarly calculate the 1.5 year zero rate by solving the following
equation:

1000 = (1000*0.092/2) / (1+0.07/2) + (1000*0.092/2) / (1+0.0884/2)^2 +

1000*(1+0.092/2) / (1+ S3/2)^3

S3 = 9.2468 %

S4 = 9.5586 %
S5 = 9.8241 %
S6 = 10.0973 %
Deriving Forward Rates

Now let us take the spot rates calculated above and assume that they are annual
zero rates.

S1 = 8.84 %

S2 = 9.5586 %

Our investment choices are:

 We can invest money at 9.5586% for two years OR

 We can invest the money for 1 year at 8.84% and roll it at maturity at the
then prevailing forward rate. But what is that forward rate, F-1x2, that
will ensure we get the same 9.5586% return after 2 years?

Assuming the same nature of investments, the returns from both choices should
be the same.

Assuming $1 as the initial investment, the value of investment in first choice

after two years:

= (1+S2)2

The value of investment in second choice after two years:

= (1+S1) * (1+ F-1x2)

If there are no arbitrage opportunities, both these values should be the same.

(1+S2)2 = (1+S1) * (1+F-1x2))

Since we have the spot rates, we can rearrange the above equation to calculate
the one-year forward rate as follows:

F-1x2 = (1+S2)2 / (1+S1) – 1

OR

F-1x2 = (1.095586^2) / (1.0884) – 1

F-1x2 = 10.28%
Using the same method, we can calculate the forward curve from the
bootstrapped zero rates as below:

Maturity Par Yield Zero Rates Forward Rate

0.5 7.00% 7.00%  Forward rates are
calculated from the
1 8.80% 8.8400% 10.3188%
relevant zero rates
1.5 9.20% 9.2468% 9.8236%  These forwards rates
2 9.50% 9.5586% 10.2373% would be labeled as
2.5 9.75% 9.8241% 10.6111% 0x6, 6x12, 12x18,
3 10.00% 10.0973% 11.1625% 18x24 and 24x36

Spot & Forward Rates Derived from Par Yields

11.50
11.00 Forwards
10.50 Zero Rates
10.00
9.50
9.00
8.50 Par Curve
8.00
7.50
7.00
6.50
6m 1Yr 1.5Yr 2Yr 2.5Yr 3Yr

Series1 Series2 Series3