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Concept
Bootstrapping (finance)
Summary
In finance, bootstrapping is a method for constructing a (zero-coupon) fixed-income yield curve from the prices of a set of coupon-bearing products, e.g. bonds and swaps.
A bootstrapped curve, correspondingly, is one where the prices of the instruments used as an input to the curve, will be an exact output, when these same instruments are valued using this curve.
Here, the term structure of spot returns is recovered from the bond yields by solving for them recursively, by forward substitution: this iterative process is called the bootstrap method.
The usefulness of bootstrapping is that using only a few carefully selected zero-coupon products, it becomes possible to derive par swap rates (forward and spot) for all maturities given the solved curve.
As stated above, the selection of the input securities is important, given that there is a general lack of data points in a yield curve (there are only a fixed number of products in the market). More importantly, because the input securities have varying coupon frequencies, the selection of the input securities is critical. It makes sense to construct a curve of zero-coupon instruments from which one can price any yield, whether forward or spot, without the need of more external information.
Note that certain assumptions (e.g. the interpolation method) will always be required.
The general methodology is as follows: (1) Define the set of yielding products - these will generally be coupon-bearing bonds; (2) Derive discount factors for the corresponding terms - these are the internal rates of return of the bonds; (3) 'Bootstrap' the zero-coupon curve, successively calibrating this curve such that it returns the prices of the inputs. A generically stated algorithm for the third step is as follows; for more detail see .
Official source
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