Bootstrapping

CFA Level II
#1

Can someone theoretically explain the bootstrapping method and why it is done in the first place? an explanation as if you would explain it to your grandmother.

#2

One of the things I would recommend in your studies is to get a feel for the areas that are important in the Level 2 curriculum and those which are not. Bootstrapping really is not that imporant and it is only covered in one LOS.

Just know that bootstrapping is used to construct a yield curve by stripping the coupon payments from long term debt securities to create zero coupon bonds for a range of maturities.

#3

Thanks Quest, but i figured i will need to understand this since LOS 46 says to explain various universes of Treasury securities that are used to construct the theoretical spot rate curve, and evaluate their advantages and disadvantages… I thought that i should know bootstrapping as it is the very basic form, but I have a hard time understanding what it is (theoretically).

#4

As Quest mentions, it’s not all that important at Level II.

However, if you’re really interested, I wrote an article on yield curves (par, spot, and forward) that includes a description of bootstrapping spot rates from par rates: http://financialexamhelp123.com/par-curve-spot-curve-and-forward-curve/.

#5

The reason they mention it is because with treasury bonds maturity terms are far apart and this would lead to gaps in the yield curve. Therefore bootstrapping is ued to strip the coupon payments from long dated treasury bonds. The present value of these coupon payments are then calculated by discounting their future values.

I would not get bogged down with any complicated calculations or the theoretical underpinnings behind bootstrapping as it will lead to brain overload

#6

Quest, you just answered the key question I had… That’'s all I needed. Magician, as always, thanks for the link. Will move on now to other topics.

#7

Got this question in the Qbank:

The following interest rate scenario is used to derive examples on the different theories used to explain the shape of the term structure and for all computational problems in Wallace’s lectures.

Table 1 LIBOR Forward Rates and Implied Spot Rates

Period

LIBOR Forward Rates

Implied Spot Rates

0 × 6

5.0000%

5.0000%

6 × 12

5.5000%

5.2498%

12 × 18

6.0000%

5.4996%

18 × 24

6.5000%

5.7492%

24 × 30

6.7500%

5.9490%

30 × 36

7.0000%

6.1238%

Wallace explains to the class that the swap fixed rate is one where the values of the floating-rate and the fixed-rate are the same at the inception of the swap. Using the information in Table 1, he asks the class to compute the swap fixed rate for a one-year plain vanilla interest rate swap with semiannual payments. Which of the following is the closest to the correct answer? A) 3.43%. B) 5.18%. C) 2.56%. Click for Answer and Explanation

First calculate the discount factors:

Z180 = 1 / {1 + [(0.05 × (180 / 360)]} = 0.9756

Z360 = 1 / {[1 + (0.052498 × (360 / 360)]} = 0.9501

The semi-annual fixed rate on the swap is:

(1 − 0.9501) / (0.9756 + 0.9501) = 2.59% × 2 = 5.18%

(Study Session 17, LOS 54.c)

Question: why do you discount using the spot rate? Can’t we discount using LIBOR? This is exactly what confuses me