By Zachary Emig, MBA Class of 2005, Ross School of Business

Bootstrapping Interest Rate Curves By Zachary Emig

1 Starting Info
Suppose we have the following Treasury yields (based roughly on Bloomberg.com, Nov. 22, 2004)
Maturity (yrs) Coupon Price 32nds Yield
0.25 na $99.46 2.17 Treasury Yields
0.50 na $98.82 2.38 4
1.00 2.250 $99.66 99 21/32 2.61 3.5
1.50 2.250 $99.28 99 9/32 2.76 3
2.00 2.500 $99.15 99 5/32 2.96 2.5
2.50 2.875 $99.63 99 20/32 3.05
2
3.00 3.000 $99.53 99 17/32 3.19
1.5
3.50 3.125 $99.64 99 20/32 3.26
4.00 3.500 $100.58 100 19/32 3.37 1
4.50 3.375 $99.64 99 20/32 3.49 0.5
5.00 3.500 $99.77 99 25/32 3.58 0
0.3 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
2 Spot Curve
The above curve reflects the yield for current securities with certain maturities.

The spot curve (or zero curve) tells us what the spot or interest rate is for a zero coupon bond of a particular maturity.
In effect, it is the discount rate applied to a single cash flow in time for any of the coupon bonds above.

We can "bootstrap" out a zero curve from the data above.

We know the 0.25 and 0.50 spot rates since they are discount securities.

Maturity (yrs) Coupon Price 32nds Yield Spot Rate

0.25 na $99.46 2.17 2.17
0.50 na $98.82 2.38 2.38
1.00 2.250 $99.66 99 21/32 2.61

A 1 Year Spot
The one year spot rate is easily found by equalizing the cash flows.

y is the yield to maturity, z1 and z2 are the two zero rates (6mo and 1yr):
C1/(1+y/2) + (100+C2)/(1+y/2)^2 = C1/(1+z1/2) + (100+C2)/(1+z2/2)^2

1.1105 + 98.5364 = 1.1118 + 101.1250/(1+Z2/2)^2

Solving for z2, the 1yr zero rate:

99.6469 = 1.1118 + 101.1250/(1+Z2/2)^2
98.5351 = 101.1250/(1+Z2/2)^2
(1+Z2/2)^2 = 1.0262836
1+Z2/2 = 1.0130566 (Square root)
Z2/2 = 0.0130566
Z2 = 2.6113 Percent

In this case, the 1 year spot rate matches the yield; that isn't always the case.

Maturity (yrs) Coupon Price 32nds Yield Spot Rate

0.25 na $99.46 2.17 2.17
0.50 na $98.82 2.38 2.38
1.00 2.250 $99.66 99 21/32 2.61 2.6113

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 By Zachary Emig, MBA Class of 2005, Ross School of Business

B Rest of Spots
Recurse through the rest of maturities, one by one, to get their spot rates.

Sum of Prior Final

Maturity (yrs) Coupon Price 32nds Yield Spot Rate Coupons' PVs Payment
0.25 na $99.46 2.17 2.17
0.50 na $98.82 2.38 2.38
1.00 2.250 $99.66 99 21/32 2.61 2.6113
1.50 2.250 $99.28 99 9/32 2.76 2.7440 2.2080 101.1250
2.00 2.500 $99.15 99 5/32 2.96 2.9448 3.6532 101.2500
2.50 2.875 $99.63 99 20/32 3.05 3.0359 5.5571 101.4375
3.00 3.000 $99.53 99 17/32 3.19 3.1784 7.1898 101.5000
3.50 3.125 $99.64 99 20/32 3.26 3.2497 8.9109 101.5625
4.00 3.500 $100.58 100 19/32 3.37 3.3651 11.5435 101.7500
4.50 3.375 $99.64 99 20/32 3.49 3.4889 12.6078 101.6875
5.00 3.500 $99.77 99 25/32 3.58 3.5835 14.5725 101.7500

Plotting the regular yield curve (in blue) versus the spot curve (in yellow):

Yield Spot Rate Yield Spot Rate

3.8 3.65
3.6 3.6
3.4 3.55
3.2
3.5
3
i 3.45 i
2.8
3.4
2.6
2.4 3.35

2.2 3.3
2 3.25
0.25 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 3.50 4.00 4.50 5.00
We can see that as maturity extends, the two curves cross.

3 Forward Curve
A forward curve is simply a graph of the x-month forward rate at different points in the future.

Unlike the other two curves, the x axis represents the "starting point" in the future for the forward contract, not
its maturity.

In this example, we'll determine the 6 month forward curve from the above information.

A 6mo Forward in 6mos

The 6mo forward rate in 6 months can be though of as what we could borrow/lend at for 6 months, 6 months from now.
Confusing enough?

By the law of no arbitrage, investing our money now for 1 year or now for 6months, with the next 6mo rate locked in,
must result in the same present value.

y is the yield to maturity, z1 is the 6mo spot rate, and f1 is the 6mo forward rate 6months from now.
C1/(1+y/2) + (100+C2)/(1+y/2)^2 = C1/(1+z1/2) + (100+C2)/(1+z1/2)(1+f1/2)

1.1105 + 98.5364 = 1.1118 + 101.1250/((1+z1/2)(1+f1/2))

Solving for f1:

99.6469 = 1.1118 + 101.1250/((1+z1/2)(1+f1/2))
98.5351 = 101.1250/((1+2.38/2)(1+f1/2))
98.5351 = 99.935764 /(1+f1/2)
(1+f1/2) = 1.0142145
f1/2 = 0.0142145
f1 = 2.8429

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 By Zachary Emig, MBA Class of 2005, Ross School of Business

Maturity (yrs) Coupon Price 32nds Yield Spot Rate 6mo Fwd Rate
0.00 2.38
0.50 na $98.82 2.38 2.38 2.8429
1.00 2.250 $99.66 99 21/32 2.61 2.6113

B Rest of Forwards
Recurse through the rest of maturities, one by one, to get the forward rates.

Maturity (yrs) Coupon Price 32nds Yield Spot Rate 6mo Fwd Rate
0.00 2.17 2.38
0.50 na $98.82 2.38 2.38 2.8429
1.00 2.250 $99.66 99 21/32 2.61 2.6113 3.0209
1.50 2.250 $99.28 99 9/32 2.76 2.7440 3.5997
2.00 2.500 $99.15 99 5/32 2.96 2.9448 3.4176
2.50 2.875 $99.63 99 20/32 3.05 3.0359 3.9537
3.00 3.000 $99.53 99 17/32 3.19 3.1784 3.6984
3.50 3.125 $99.64 99 20/32 3.26 3.2497 4.2473
4.00 3.500 $100.58 100 19/32 3.37 3.3651 4.5875
4.50 3.375 $99.64 99 20/32 3.49 3.4889 4.5123
5.00 3.500 $99.77 99 25/32 3.58 3.5835

Yield Spot Rate 6mo Fwd Rate

5

4.5

3.5

2.5

2
0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00

3 Summarizing the Curves

To summarize:

Yield Curve Yields are bond-specific; given a bond's market price and coupons, the yield
is the average rate that all cash flows are discounted at to make present and
future values the same.
Spot Curve The spot curve diagrams what pure discount rate the market applies to any
cash flow at each maturity point. It is not bond specific.
Also called the zero curve.
Forward Curve This is a plot of what the market charges to borrow money for a 6 month
period starting at certain future dates.
Note that forward curves could be made for any borrowing term
(i.e. 1 year forwards, 3 month forwards, etc.)

Disclaimer
This is a very rudimentary example. In practice, bootstrapping is a much more difficult process, mainly due to the difficulty
of getting a clean, accurate original yield curve. There are not actively traded Treasury securities at every maturity point.
The Treasury no longer issues 30 year Bonds, making the long end of the curve tricky. Etc., etc.
This worksheet is meant more as an explanation for the concept of bootstrapping, the process of generating a
spot curve from a yield curve, and a forward curve from a spot curve.

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 By Zachary Emig, MBA Class of 2005, Ross School of Business

Pricing Interest Rate Swaps

1 Starting Info
We have the following rate curves (from the Bootstrapping worksheet). I've added LIBOR spot and 6mo fwd rates.
LIBOR Spot
Maturity (yrs) Coupon Price 32nds Yield Spot Rate 6mo Fwd Rate Rates
0.00 2.38
0.50 na $98.82 2.38 2.38 2.8429 2.8800
1.00 2.250 $99.66 99 21/32 2.61 2.6113 3.0209 3.1113
1.50 2.250 $99.28 99 9/32 2.76 2.7440 3.5997 3.2640
2.00 2.500 $99.15 99 5/32 2.96 2.9448 3.4176 3.6348
2.50 2.875 $99.63 99 20/32 3.05 3.0359 3.9537 3.6459
3.00 3.000 $99.53 99 17/32 3.19 3.1784 3.6984 3.7884
3.50 3.125 $99.64 99 20/32 3.26 3.2497 4.2473 3.7997
4.00 3.500 $100.58 100 19/32 3.37 3.3651 4.5875 3.9451
4.50 3.375 $99.64 99 20/32 3.49 3.4889 4.5123 4.0789
5.00 3.500 $99.77 99 25/32 3.58 3.5835 4.1735

I created the LIBOR forward rates simply because most IR Swaps use LIBOR for the floating leg.

Yield Spot Rate 6mo Fwd Rate

5.5 LIBOR Spot Rates LIBOR 6mo Fwd Rate

4.5

3.5

2.5

2
0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00

2 Swap Info
Assume we want to buy (go long) a swap, i.e. pay a fixed rate, receive floating (LIBOR 6mo).
Here are the contract details I'm looking for:

Notional $100,000,000
Term (Years) 4
Settlement Every 6mos
Floating Rate LIBOR 6mo

3 Pricing
So we are expecting, based on LIBOR forward rates to receive the following 8 cash inflows.
We can discount each using the [LIBOR] spot rates.

6mo LIBOR LIBOR Discount PV of Cash

Time (Years) Fwd Rate Cash Flow In Spot Rate Factor In
0.00 2.8800 0 0.0000 0 0
0.50 3.3429 $2,880,000 2.8800 0.9858 $2,839,117
1.00 3.5697 $3,342,897 3.1113 0.9696 $3,241,266
1.50 4.7513 $3,569,689 3.2640 0.9526 $3,400,471
2.00 3.6905 $4,751,328 3.6348 0.9305 $4,421,065
2.50 4.5024 $3,690,508 3.6459 0.9136 $3,371,765
3.00 3.8673 $4,502,399 3.7884 0.8935 $4,022,969
3.50 4.9659 $3,867,317 3.7997 0.8766 $3,389,962
4.00 $4,965,916 3.9451 0.8553 $4,247,494
Total PV of Floating Payments $28,934,109

Naturally, in a no-arbitrage world, the PV of the fixed payments we make out must also be
$28,934,109 .

Do the math; the fixed leg of the swap is simply an annuity:

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 By Zachary Emig, MBA Class of 2005, Ross School of Business

$28,934,109 = Pmt * Sum ( Discountfactors )

$28,934,109 = Pmt * 7.3775
$3,921,922 = Pmt

Thus, the fixed interest rate is $3,921,922 / $100,000,000

3.9219

This would probably be quoted at a spread over the equivalent (4yr Treasury):
55.2 bp

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 By Zachary Emig, MBA Class of 2005, Ross School of Business

By Zachary Emig

LIBOR 6mo Fwd

Rate
2.8800
3.3429
3.5697
4.7513
3.6905
4.5024
3.8673
4.9659
5.1522
5.0273

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