Session 9_10

Yield Curve
Derivation of Zero
Coupon Yield Curve
FIS 2024
Dr. Himanshu Joshi
FORE School of Management
New Delhi
Yield Curve or Term Structure of
Interest Rates
• Plots the relationship among interest rates of bonds with different
maturities.
• For example, the Treasury yield curve plots the yields of government
treasury securities, with maturities ranging from one month to 30/40
years.
• Bonds with similar characteristics, how yields across a range of
maturities differ.
• Not, the yield on different types of bonds that have the same maturity
– for example, a 2-year Aaa note vs a 2-year Baa note. Yield will differ
because of what is called a risk premium.
The Risk Premium
• The risk premium encompass risk differentials that owe to default or credit
risk (a Baa bond is riskier than a Aaa bond) but also to a liquidity premium.
• All else equal, investors should demand higher returns for less liquid
securities.
• The benchmark (risk-free) interest rate is that on an on-the-run Treasury
securities; all other debt securities should offer a premium relative to the
benchmark rate, and risk spreads are usually quoted vis-à-vis a Treasury bond.
• Risk-free is not truly without risk. Even a benchmark security has reinvestment
risk (if rates decrease then coupon payments can only be reinvested at lower
yield) and price or interest rate risk (if bond is not held to maturity and rates
rises, it can only be sold for a loss).
 2. India 3. Japan
1. US

4. Brazil 5. Switzerland 6. China

What should be the ideal shape of
the Yield Curve?
Maturity (x) and Duration (Y)
14

12

10

0
0 20 40 60 80 100 120
Yield Curves: Shapes and Empirical
Regularities
• Upward sloping (if long term rates are higher than short rates).
• Flat
• Inverted (when long rates are lower than short rates).
• Can have kinks (^) or bumps (∩).
Yield Curve Analysis
• A comprehensive analysis of yield curve must explain why the yield curve
is shaped differently at different times but also must encompass the
following empirical regularities.
1. Rates on bonds of different maturities tend to move together. This is
not one-for-one relation, but often the whole yield curve will shift up
or down (although perhaps to varying degrees at different ends of the
curve).
2. When short rates are low, the yield curve tends to slope upward.
Inverted yield curves often occurs when short rates are high.
3. The norm is an upward-slopping yield curve. Flat or inverted yield
curves are uncommon. (this is text book approach).
Yield Curve..
Q. Why does the curve not continue to slope upwards, all the way to
the 30 year mark?
• This is a peculiarity of many markets – the 10 year and 30 year bond,
commonly called the long bonds, are usually in such high demand
among the institutional investors such as pension funds, that this
demand outstrips supply.
• As a result, the price of this bond is forced upwards, and this moves
the yield down to below what it should be.
Empirical Evidence of Term
Structure..
• Recession 1969 Quarter 4-1970 Quarter 4, Total GDP declines is .1%.
Term structure begins inversion in 1968 quarter 3 correctly. (predicts
the recession four Quarter in advance.)
Recession 1973 Quarter 4-1975Quarter 1, total GDP decline is 4.2%.
Term structure begins inversion in 1973 Quarter 2 Correctly. (predict
the recession with a two quarter lead time.)
Empirical Evidence..
• Recession 1980 Quarter 1 -1980 Quarter 3, total GDP decline is 2.6%.
• Term structure begins inversion in 1978 Quarter 4 correctly. (predicts
the downturn with a five quarter lead.)
• Recession 1990 Quarter 3-1991 Quarter 1, total GDP decline is 1.8%.
• Term structure shows inversion in 1989 Quarter 2.
Yield Curve Theories
• Expectation Theory
• Segmented Market Theory
• Liquidity Premium Theory
The Expectations Theory
• The expectation theory states that long-term rates represent
expectations of short-term rates over the life of the long-term bond.
• For example, if the market expects short rates to remain at 5% for the
next 10-years, then a 10-year bond should offer 5% yield. In this case
(ignoring transaction costs) an investor would be indifferent between
holding the 5% 10-year bond or rolling over a sequence of 5% 1-year
bonds.
• That indifference implies that investors view bonds of different
maturities as perfect substitutes.
Two 2-Year Investment Programs
Expectation Theory

2. Acting as an indicator of future yield levels For Rising Yield Curve (Y1=5%, Y2=6%)
• 890(1.05)(1+r2) = 890(1.06)2
 r2 = 7%
• For Flat Yield Curve (Y1=Y2=5%)
 r2 = 5%
• For Declining Yield Curve
(Y1=5%, Y2= 4%)
 r3 = 3%
The Expectation Theory
• When yield curve is upward-sloping investors expect short rates to
increase in the future; for whatever reason (e.g., monetary policy is
loose – short rates are low currently, but in future they are expected
to increase.
• Similarly, an inverted yield curve would indicate that the market
expects short rates to fall in the future (perhaps for example, a
recession is on the horizon, and the RBI will aggressively lower the
short rates to combat it).
Expectation Theory
• Because yield curves are typically upward-slopping, the expectations
theory suggests that the market almost always expects short rates to
increase in the future.
• That is a major deficiency in the theory and indicates that by itself the
expectation theory cannot explain the shape of the yield curve.
2. The Segmented Market Theory
• The segmented market theory relaxes the perfect market assumption
and recognizes that markets for different maturities might be
segmented or separate.
• You can think of this as each point on the yield curve being the result
of supply and demand for that maturity, with no interaction between
markets for different maturities.
• For that to be true, investors must have exceedingly strong
preferences for holding bonds of a certain maturity.
Does it explain the shape of the yield curve??
2. Segmented Market Theory
• The segmented markets theory provides a sensible explanation of the
fact that yield curves are typically upward-sloping.
• Longer term bonds have greater reinvestment and price risk and so
should have a positive risk premium. (or because of higher liquidity
and lower risk investor would prefer to hold short term maturity
bonds  leading to more demand  higher pricing  lower yields.
The Segmented Market Theory
• A less stringent cousin of the segmented market theory is the
preferred habitat theory, which allows for certain maturity
preferences but assumes that investors have some willingness to shift
between maturities.
• For example – a life insurance company with long-dated liabilities
might have a strong preference for long-dated assets, but at times
they might opportunistically move to other portions of the yield
curve.
Limitation of the Segmented Market
Hypothesis..
• Theory cannot explain why the whole yield curve tends to upward
sloping when short rates are low (why should the level of short rates
affects the supply and demand of long-term bonds).
3. The Liquidity Premium Theory
• This theory combines the best features of the first two: long term
rates equal the average short rates expected to occur over the life of
the bond plus a liquidity premium (term premium) that owes to
supply and demand conditions for the particular bond.
• In this theory bonds of different maturities are not completely
segmented, but nor are they perfect substitutes, there is some link
between maturities, but the term premium represents a wedge that is
not present in the expectation theory.
The Liquidity Premium Theory
• The liquidity premium theory is consistent with all three empirical regularities. It
allows rates for different maturities to be linked (but not perfectly so).
• It allows for a steep upward-slopping yield curve when short rates are low;
investors may expect short rates to increase and this coupled with term
premium, leads to sharply higher long rates.
• It also allows for the typical shape of the yield curve to be upward-sloping; with
a term premium.
• For the yield curve to be flat or inverted investors would have to expect short
rates to fall subsequently in the future. (less demand for short term bonds now
because of higher reinvestment risk  higher demand for the long term bonds 
higher prices of long term bonds  lower yields on the long term bonds 
inverted yield curve.
Uses of the Yield Curve
• Yield curve tells us where the bond market is trading now.
• It also implies the level of trading for the future, or at least what the
market thinks will be happening in the future.
• All participants in the debt capital market have interest in the current
shape and level of the yield curve, as well as what information implies
for the future.
US Government Benchmark Yield
Curve November 05, 2024 12:17 PM
US Government Benchmark Yield
Curve
Interpretation of US Benchmark
Yield Curve
• The U.S. Treasury yield curve shown in the image displays the yields on government securities across
different maturities, from 1 month to 30 years.
• Here’s a breakdown of its shape and implications: Inversion in the Short Term: The curve starts with a
downward slope from 1 month to around 2-3 years, indicating that shorter-term yields are higher
than intermediate-term yields. This inversion (where shorter-term yields exceed longer-term yields) is
often a sign of economic uncertainty or expectations of future interest rate cuts by the Federal
Reserve, possibly due to anticipated economic slowdown or recessionary pressures.
• Recovery and Peak at the Mid-Range: Yields begin to increase again after 3 years, peaking around the
20-year mark. This upward slope from intermediate-term to long-term suggests some normalization
of rates, possibly due to long-term inflation expectations or a stabilization in economic forecasts.
• Slight Decline at the Long End: Beyond the 20-year point, the yield curve slopes slightly downward as
it approaches the 30-year maturity. This small dip could imply a long-term outlook where the
demand for very long-term bonds is higher, potentially because investors are seeking safety in long-
term government bonds. Such behavior often indicates a cautious economic outlook extending far
into the future.
Interpretation of US Benchmark
Yield Curve
• Economic Signals: This mixed yield curve, with a notable inversion in the short-
term followed by an upward slope, suggests a complicated economic outlook.
• The inversion is a typical signal of recessionary concerns, while the upward
movement in the mid-to-long term may indicate that markets expect interest
rates to normalize after a potential economic slowdown.
• Federal Reserve Policy: The steep short-term yields may reflect current high
interest rates from the Federal Reserve as it combats inflation. However, the mid-
to long-term structure hints at expectations that rates may stabilize or even fall in
the future.
• This yield curve is closely watched by investors as a predictor of economic
conditions, with inverted sections commonly seen as indicators of an
approaching recession if sustained over time.
Indian Government Benchmark Yield
Curve
November 05, 2024 12:21 PM
Indian Government Benchmark Yield
Curve
Interpretation of Indian Benchmark
Yield Curve
• Steep Start in Short-Term: The yield curve begins with a sharp upward slope from 3 months
to around 1 year, indicating that shorter-term yields are relatively high. This upward slope at
the short end is common in yield curves and suggests that the market expects relatively high
interest rates in the near term, possibly due to concerns about inflation or central bank
policies.
• Fluctuations in the Mid-Range: The curve shows some fluctuations in the mid-range (around
5-10 years), with minor peaks and troughs. These fluctuations can imply uncertainty about
future economic conditions or inflation expectations, leading to varying demand for mid-
term securities.
• Gradual Upward Slope to the Long Term: After the mid-range, the yield curve stabilizes and
then gradually slopes upwards towards the 40-year maturity, reaching around 7%. This long
upward slope could indicate that investors expect steady economic growth or moderate
inflation in the long term, with demand for longer-term bonds requiring a slightly higher
yield to compensate for potential inflation and interest rate risks over an extended period.
US- India Comparison
• No Inversion: Unlike the U.S. yield curve, the Indian yield curve does not show
any inversion. This suggests that the Indian economy might not be experiencing
the same level of recessionary pressures seen in other economies, as there’s no
signal of anticipated rate cuts or economic downturn.
• Interpretation: The steepness at the short end indicates tight monetary policy
to control inflation, with the Reserve Bank of India likely maintaining higher
rates in the short term. The stable upward trend in the long term reflects
investor confidence in the economy's growth potential and a relatively stable
outlook for inflation over time.
• This yield curve structure suggests a stable yet cautious economic outlook, with
high short-term rates to combat inflation and a long-term outlook that
anticipates growth without significant volatility.
Steepening Yield Curve Implications
- Equity
• Stronger Economy
• Increased Demand: A steepening yield curve often indicates stronger economic activity and
rising inflation expectations. This environment typically supports cyclical sectors which
benefit from increased demand and higher production volumes1.
• Corporate Performance: Stronger economies generally translate to better corporate
performance, leading to improved earnings and stock prices for companies operating in
growth-oriented industries.
• Equity Strategy – 1. Sector Rotation 2. Cyclical Sectors
• Outperformance: Historical data suggests that banks and other financial institutions tend to
outperform during periods of yield curve steepening. Banks benefit from borrowing money
at lower short-term rates and lending at higher long-term rates, thereby increasing their
profit margins1.
• Cyclical Industries: Other cyclical sectors such as consumer discretionary goods, industrials,
and materials may also perform well as they are more sensitive to changes in economic
activity1.
Yield Curve Implications - Equity
• Equities Tend to Perform Well
• Rate Cuts: When interest rate cuts accompany a steepening yield
curve, equities have historically performed impressively. For instance,
after the initial rate cut, there has been an average gain of around
20% in equity markets over the subsequent year provided no
recession ensues1
•.
• Risk Appetite: Increased confidence in future economic prospects can
boost risk appetite among investors, driving up share prices across
various sectors
Yield Curve Implications – Fixed
Income
1. Interest Rate Expectations
• Rising Long-Term Yields: A steepening yield curve typically indicates
that long-term interest rates are rising faster than short-term rates.
This can occur due to expectations of stronger economic growth or
rising inflation.
• Impact on Bond Prices: As long-term yields rise, the prices of existing
long-term bonds will generally fall. This poses a risk for fixed income
investors holding these securities, as they may face capital losses if
they need to sell before maturity.
Yield Curve Implications – Fixed
Income
2. Portfolio Reallocation
• Duration Management: Fixed income investors may need to adjust
the duration of their portfolios. A steepening curve suggests that
longer-duration bonds may be more sensitive to interest rate changes,
prompting investors to shorten their duration to mitigate risk.
• Barbell Strategy: Investors might adopt a barbell strategy, maintaining
positions in both short-term and long-term bonds while avoiding
intermediate maturities. This allows them to benefit from higher
yields on long-term bonds while reducing exposure to interest rate
risk associated with intermediate bonds.
Yield Curve Implications – Fixed
Income
3. Opportunities in New Issuance
• Attractive New Bonds: As yields rise, new bond issuances may offer
more attractive rates, providing opportunities for fixed income
investors to reinvest at higher yields.
• Increased Supply: A steepening yield curve can lead to increased
issuance of government and corporate bonds as issuers seek to take
advantage of favorable borrowing conditions before rates rise further.
Japan Government Benchmark Yield
Curve
Brazil Government Benchmark Yield
Curve
Switzerland Government Benchmark
Yield Curve
China Government Benchmark Yield
Curve
Figure- Treasury Yield Curves
Yield Curve Applications
1. Setting the yield for all debt market instruments (Reference Rate)
The yield curve essentially fixes the cost of money over the maturity
term structure.
The yield from government bonds from the shortest maturity to the
longest maturity set the benchmark for yield for all other debt
instruments in the market.
Issuers of debt and their underwriting banks therefore use the yield
curve to price bonds and all other instruments.
Generally zero-coupon yield curve is used to price new securities, not
on the run yield curve.
Yield Curve Applications
2. Acting as an indicator of future yield levels
Yield curve assumes certain shapes in response to market expectations
of the future interest rates.
Bond market participants analyze the present shape of the yield curve
in an effort to determine the implications regarding the future direction
of market interest rates.
Yield curve is scrutinized for its information content, not just regarding
forward interest rates, but also with regard to the expectations about
inflation levels.
Yield Curve Applications

2. Acting as an indicator of future yield levels For Rising Yield Curve (Y1=5%, Y2=6%)
• 890(1.05)(1+r2) = 890(1.06)2
 r2 = 7%
• For Flat Yield Curve (Y1=Y2=5%)
 r2 = 5%
• For Declining Yield Curve
(Y1=5%, Y2= 4%)
 r3 = 3%
Figure 15.2 Two 2-Year Investment
Programs
Yield Curve Under Certainty
• Remember both strategies must provide equal returns as neither
entails any risk:
• Buy and Hold two year zero = Rollover 1 year Bond
• $890 (1.06)2 = $890 (1.05) (1+r2)
Figure 15.3 Short Rates versus Spot
Rates
Yield Curve Applications
3. Measuring and Comparing Returns across the Maturity Spectrum
The Yield Curve indicates the returns that are available at different
maturity points.
Fixed income fund managers use it to access which point of the curve
offers the best returns relative to other points.
3# Measuring and Comparing
Returns across the Maturity
Spectrum Redemption Yield
5

2020 4.5

Gilt Redemption Yield Maturity 4

Tr 8% 21 3.79 1 3.5
Tr 5% 22 4 2
3
Tr 7.25% 25 4.62 5
2.5
Tr 5% 30 4.7 10
Tr 8.75% 35 4.74 15 2

Tr 8% 39 4.68 19 1.5

Tr 4.25% 50 4.52 30 1

0.5

0
0 5 10 15 20 25 30 35
Yield Curve Applications
4. Indicating Relative Value
between Different Bonds of
Relative Value between different bonds of Similar
Similar Maturity 8
Maturity

The yield curve can be analyzed to 7

indicate which bonds are cheap or

6

dear to the curve. 4

Placing bonds relative to zero- 2

coupon yield curve helps to 1

highlight which bonds should be 2015 2020 2025 2030 2035

Zero Coupon Yield Curve

2040 2045

Corporate Bond AAA

2050 2055

bought or sold. Corporate Bond AA

Yield Curve Applications
5. Pricing Interest Rate Derivative Securities
The price of derivative securities revolves around the yield curve.
At the short end, Products such as Forward Rate Agreements (FRAs) are
priced off the future curve, but futures rate reflect the market’s view on
forward three-month cash deposit rates.
At the long end, Interest Rate Swaps are priced off the yield curve, while
hybrid instruments that incorporate option features such as convertibles and
callable bonds also reflect current yield curve levels.
The risk free interest rate which is one of the parameter used in option
pricing, the T-bill rate or short term government repo rate both are
constituents of money market yield curve.
Different Types of Yield Curves
• The Yield to Maturity Curve
• The Coupon Yield Curve
• The Par Yield Curve
• The Zero Coupon (or Spot) Yield Curve
1. Yield to Maturity Curve
• It is most commonly observed curve simply because YTM is the most
frequent measure of return used.
• The curve is constructed by plotting the yield to maturity (YTM)
against the term to maturity for a group of bonds of the same class.
• Main weakness of the yield to maturity measure, which is the
assumption of a constant rate for coupon reinvestment during the
bond’s life at the redemption yield level. Since market rates fluctuate
over time, it is not possible to achieve this (reinvestment risk).
• Only zero coupon bondholders avoid reinvestment risk as no coupon
is paid during the life of a zero-coupon bond.
1. Yield to Maturity Curve
• The yield to maturity curve does not distinguish between different payment
patterns that may result from bonds with different coupons, that is, the fact that
low-coupon bonds pay a higher portion of their cash flows at a later date than high
coupon bonds of the same maturity. The curve also assumes an even cash flow
pattern for all bonds. Therefore in this case, cash flows are not discounted at the
appropriate rate for the bonds in the group being used to construct the curve.

Price P  9% Coupon Bond

Duration << Maturity

Price P 4% Coupon Bond

Duration < Maturity
Price P  0% Coupon Bond
Duration = Maturity
1. Yield to Maturity Curve –
Reinvestment Risk
• To compensate for this, bond analyst may sometimes construct a
coupon yield curve, which plots yield to maturity against term to
maturity for a group of bonds with the same coupon.
• This may be useful when a group of bonds contains some with very
high coupons.
• High coupon bonds often trade “cheap to the curve”, that is they have
higher yields (lower prices) than corresponding bonds of the same
maturity but lower coupon. This is usually because of reinvestment
risk and, in some markets (including the UK), for tax reasons.
1. Yield to Maturity Curve – Tax Risk
• In the UK, for example, on gilt the coupon is taxed as income tax,
while any capital gain is exempt from capital gain tax.
• In other jurisdictions where capital gain on the bonds is taxable, this
can often be deferred whereas income tax cannot.
• Therefore, high coupon bonds attract higher tax payment in
comparison to the lower coupon bonds.
• If higher coupon bonds and lower bonds trades at same yield
(different prices) for the same maturity, for the tax purpose investors
would prefer low coupon bonds to the higher coupon bonds.
Yield to Maturity Curve –
Limitations..
• YTM and YTM curve, is really just an “assumed” yield. It isn’t a true
term structure of interest rates.
• This is because, for the investor to receive the YTM during the period
the bond is held, the bond must have been –
(i) Purchased at par, and (ii) all the coupons received during the
holding period must have been reinvested at the same YTM.
These two sets of conditions are rarely met during the holding period.
Therefore, YTM is a useful measure for initial purchase and comparison
purposes, but it is rarely the return that is actually received.
2. The Coupon Yield Curve
• The coupon rate yield curve is a plot of the yield to maturity against
term to maturity for a group of bonds with the same coupon.
• If we construct such a curve, we can see that in general high-coupon
bonds trade at a discount (have higher yields) relative to low coupon
bonds, because of reinvestment risk and for tax reasons.
• It is frequently the case that yields vary considerably with coupon for
the same term to maturity, and with term to maturity for different
coupons.
• In other words, usually we observe different coupon curves, not only
at different levels, but also with different shapes.
Coupon Yield Curve
• Distortions arise in yield to
maturity curve if no allowance is
made for coupon differences.

• For this reason, bond analysts

frequently draw a ‘line of best
fit’ through a plot of
redemption yields, because the
coupon effect in a group of
bonds will produce a curve with
humps and troughs.
The Par Yield Curve
• The par yield curve is not usually encountered in secondary market trading,
however, it is often constructed for use by corporate financiers and others in the
new issues or primary market.
• The par yield curve plots yield to maturity against term to maturity for current
bonds trading at par.
• The par yield is therefore equal to the coupon rate for bonds priced at par or near
to par, as the yield to maturity for bonds exactly at par is equal to the coupon
rate.
• Those involved in the primary market will use a par yield curve to determine the
required coupon for a new bond that is to be issued at par.
• This is because investors prefer not to pay over par for a new issue bond, so the
bond requires a coupon that will result in a price at or slightly below par.
The Par Yield Curve
• If bonds in the market are trading substantially away from par then
the resulting curve will be distorted.
• Market can use actual non-par vanilla bond yield curves to derive
zero-coupon yield curves and then constructs hypothetical par yields
that would be observed were there any par bonds being traded.
The Zero-Coupon (or Spot) Yield
Curve
• The Zero-coupon (or spot) yield curve plots zero-coupon yields (or
spot yields) against term to maturity.
• A zero coupon yield is the yield prevailing on a bond that has no
coupons.
• In the first instance, if there is a liquid zero coupon bond market we
can plot the yields from these bonds if we wish to construct this
curve.
• However, it is not necessary to have a set of zero coupon bonds to
construct the curve, we can derive it from a coupon or par yield
curve.
The Zero-Coupon (or Spot) Yield
Curve
• Many markets where no zero-coupon bonds are traded, a spot yield
curve is derived from the conventional yield to maturity curve.
• This is of course a theoretical zero-coupon (spot) yield curve, as
opposed to the market or observed spot curve that can be
constructed using the yields of actual zero-coupon bonds trading in
the market.
Interest Rates: Basic Concepts
Bootstrapping Procedure.
Bond Price Year 1 Year 2 Year 3
1 99.50 105 0 0
• Consider the problem of finding the 2 101.25 6 106 0
pure discount bond prices from the
3 100.25 7 7 107
coupon bond prices that are available.
Table gives data for three bonds for a The spot rate yj for a pure discount bond maturing j
period of three years. years from now may be defined as the discount
rate at which present value of the promised
• Bond 1 has maturity of 1 year has terminal cash flow of the pure discount bond is
coupon rate of 5% and selling at a equal to its price. Zj is the price today of a pure
price of 99.50. discount bond paying $100 in j periods, then
• Bond 2 has maturity of 2 years pays Zj =
coupon of 6% annual and selling at a
price of 101.25.
• Bond 3 has maturity of 3 years and
pays coupon of 7% annual, selling at a
price of 100.25.
Bootstrapping – 1 Year Zero..
• Let Pi be the price of bond i. Let Ci denote the dollar coupon
associated with bond I, then we can denote the price of the first bond
as 
Yield on First Bond
• P1 = 100 + C1/(1+y1)1 Settlment Date 01-01-2020

• 99.50 = (100+5)/(1+y1)1 Maturity Date 01-01-2021

Coupon 5%

Z1 =
Price 99.5

Redemption 100

Frequency 1

Basis 0

Yield to Maturity 5.53%

Bootstrapping – 2 Year Zero
• Armed with the knowledge of y1 we can determine y2. to do this,
recognize that the price of Bond 2 can be written in terms of the two
spot rates of interest as –
• P2 = = 101.25
• Use Goal seek function in excel y2 = 5.3185%
• Z2 =
Bootstrapping – 3 Year Zero
• Armed with the knowledge of y1, and y2 we can determine y3. To do
this, recognize that the price of Bond 3 can be written in terms of the
three spot rates of interest as –
• P3 = + = 100.25
• Use Goal seek function in excel y3 = 7.0155%
• Z3 =
 Yield to Maturity Curve and Spot
Yield Curve
Maturity Implied Zero Price Spot Rate of Interest
Yield to Maturity Curve and Spot Yield Curve
1 0.9476 5.5276% 8.0000%

2 0.9015 5.3185% 7.0000%

6.0000%
3 0.8159 7.0155%
5.0000%

4.0000%

3.0000%

Yield to Maturity Spot Rate Yield (Zero) Difference 2.0000%

1 5.5300% 5.5300% 0.0000% 1.0000%

0.0000%
2 5.3200% 5.3185% 0.0015% 0.5 1 1.5 2 2.5 3 3.5

Yield to Maturity Spot Rate Yield (Zero)

3 6.9000% 7.0155% -0.1155%
Bootstrapping..
• We can rewrite the price of the three-year coupon bond as
• P3 = 7 z1 + 7 z2 + 107 z3
• Zj is the price of zero today, which pays a dollar j periods from now.
• Above equation states that the price of a 3-year coupon bond is a
portfolio of zero coupon bonds; if we buy 7 units of a one-year zero, 7
units of a two-year zero, and 107 units of a three-year zero.
• The payoff of such a portfolio will be identical to the three year
coupon bonds.
Bootstrapping..
• We can state the general relationship between coupon bond prices
and spot rates of interest.
• We used the information on coupon bond prices as input to derive
the zero coupon bond prices. Such estimates of zero coupon prices
are known as implied zeros, since they are implied by coupon bond
prices. We can denote the cash flow information about coupon bonds
as Matrix 
105 0 0
• A =6 106 0
7 7 107
Bootstrapping..
• Let’s denote by P = [99.50, 101.25, 100.25] the vector of bond prices.
• Let z = [z1 z2 z3 ] be the vector of zero prices.
• Then the zero bond prices and the coupon bond prices satisfy the
relation P = A * z
• This notation is a compact mathematical way of saying that
the prices of bonds are the sum of discounted cash flows.
• We can solve for the zero prices by inverting matrix A:
• z = A -1 * P
Bootstrapping..
• This way of extracting implied zero prices from coupon bond price will
be useful when there are many coupon bonds with regular and
uniform maturity intervals.
Using Matrix for Deriving Pure (Zero)
Yield Curve
• Coupon Bond Prices of Various Treasury Securities for Settlement on
October 9, 1999.
Coupon Bond Prices Settlement Date 09-10-1999 15-08-1999
Maturity Date Coupon Bid Clean Ask Clean
15-02-2000 5.0000% 100.05 100.07
15-08-2000 8.0000% 103 103.02
15-02-2001 8.2500% 105.1 105.12
15-08-2001 8.7500% 107.29 107.31
15-02-2002 11.7500% 116.16 116.18
15-08-2002 7.8750% 109.1 109.12
15-02-2003 14.2500% 130.1 130.12
15-08-2003 6.2500% 106.09 106.11
15-02-2004 6.2500% 107.02 107.04
15-08-2004 5.7500% 105.21 105.23
15-02-2005 5.8750% 106.22 106.24
15-08-2005 7.2500% 113.24 113.26
15-02-2006 7.5000% 115.29 115.31
Using Matrix for Deriving Pure (Zero)
Yield Curve
• Based on this information, construct the implied zero curve as of the settlement
date out to February 15, 2006, by following steps 
• Step 1. we first determine the dirty prices of each bond. Note that for each bond
we need to compute accrued interest and add it to the clean price to get the
dirty price. Clean bond prices are generally quoted in 32nd, we need to convert
these into decimals.
• Step 2. Next we determine the cash-flow matrix A.
• Step 3. Next we determine the inverse of the cash flow matrix A-1, using the excel
function ‘=MINVERSE”.
• Step 4. We multiply the inverse of the cash flow matrix and the vector of the dirty
prices to get the vector of implied zero prices (z) using excel function ‘-MMULT’
• Step 5. Use Zero Prices to calculate Zero Yields.
Using Matrix for Deriving Pure (Zero)
Yield Curve
Step 1. Calculating dirty prices
• Accrued Interest = (100* Semiannual Coupon Rate) *
• Days Accrued = Settlement Date (October 9, 1999) – August 15, 1999 = 55 days
• Converting 32nd Prices into Decimal Price using Excel Function  ‘DOLLARDE(32nd Price,
32)
• Calculate Dirty Price = Clean Price (decimal) +Accrued Interest
• This will produce Vector of Coupon Paying Bond Prices  P
 Using Matrix for Deriving Pure (Zero)
Yield Curve
• Step 2. Determine the cash-flow Matrix A 
Maturity Date 15-02-2000 15-08-2000 15-02-2001 15-08-2001 15-02-2002 15-08-2002 15-02-2003 15-08-2003 15-02-2004 15-08-2004 15-02-2005 15-08-2005 15-02-2006

15-02-2000 102.5000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

15-08-2000 4.0000 104.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

15-02-2001 4.1250 4.1250 104.1250 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

15-08-2001 4.3750 4.3750 4.3750 104.3750 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

15-02-2002 5.8750 5.8750 5.8750 5.8750 105.8750 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

15-08-2002 3.9375 3.9375 3.9375 3.9375 3.9375 103.9375 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

15-02-2003 7.1250 7.1250 7.1250 7.1250 7.1250 7.1250 107.1250 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

15-08-2003 3.1250 3.1250 3.1250 3.1250 3.1250 3.1250 3.1250 103.1250 0.0000 0.0000 0.0000 0.0000 0.0000

15-02-2004 3.1250 3.1250 3.1250 3.1250 3.1250 3.1250 3.1250 3.1250 103.1250 0.0000 0.0000 0.0000 0.0000

15-08-2004 2.8750 2.8750 2.8750 2.8750 2.8750 2.8750 2.8750 2.8750 2.8750 102.8750 0.0000 0.0000 0.0000

15-02-2005 2.9375 2.9375 2.9375 2.9375 2.9375 2.9375 2.9375 2.9375 2.9375 2.9375 102.9375 0.0000 0.0000

15-08-2005 3.6250 3.6250 3.6250 3.6250 3.6250 3.6250 3.6250 3.6250 3.6250 3.6250 3.6250 103.6250 0.0000

15-02-2006 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 3.7500 103.7500
 Using Matrix for Deriving Pure (Zero)
Yield Curve
• Step 3. Next we determine the inverse of the cash flow matrix A-1,
using the excel function ‘=MINVERSE’
• A-1 has 13 rows and 13 columns. To obtain the inverse we first mask
off a 13X13 space in the worksheet where we want inverse to be
placed. Then we insert the command = MINVERSE(), then follow by
pressing simultaneously CTRL+SHIFT+ENTER.
Maturity Date 15-02-2000 15-08-2000 15-02-2001 15-08-2001 15-02-2002 15-08-2002 15-02-2003 15-08-2003 15-02-2004 15-08-2004 15-02-2005 15-08-2005 15-02-2006
15-02-2000 0.0098 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
15-08-2000 -0.0004 0.0096 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
15-02-2001 -0.0004 -0.0004 0.0096 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
15-08-2001 -0.0004 -0.0004 -0.0004 0.0096 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
15-02-2002 -0.0005 -0.0005 -0.0005 -0.0005 0.0094 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
15-08-2002 -0.0003 -0.0003 -0.0003 -0.0003 -0.0004 0.0096 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
15-02-2003 -0.0005 -0.0005 -0.0006 -0.0006 -0.0006 -0.0006 0.0093 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
15-08-2003 -0.0002 -0.0002 -0.0002 -0.0002 -0.0003 -0.0003 -0.0003 0.0097 0.0000 0.0000 0.0000 0.0000 0.0000
15-02-2004 -0.0002 -0.0002 -0.0002 -0.0002 -0.0002 -0.0003 -0.0003 -0.0003 0.0097 0.0000 0.0000 0.0000 0.0000
15-08-2004 -0.0002 -0.0002 -0.0002 -0.0002 -0.0002 -0.0002 -0.0002 -0.0003 -0.0003 0.0097 0.0000 0.0000 0.0000
15-02-2005 -0.0002 -0.0002 -0.0002 -0.0002 -0.0002 -0.0002 -0.0002 -0.0003 -0.0003 -0.0003 0.0097 0.0000 0.0000
15-08-2005 -0.0002 -0.0002 -0.0002 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 0.0097 0.0000
15-02-2006 -0.0002 -0.0002 -0.0002 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 -0.0003 0.0096
Using Matrix for Deriving Pure (Zero)
Yield Curve
• Step 4. We multiply the inverse Maturity Date Maturity Zero Price
of the cash flow matrix and the 15-02-2000 0.70 0.9844

vector of the dirty prices to get 15-08-2000 1.69 0.9640

the vector of implied zero prices 15-02-2001

15-08-2001
2.69

3.67
0.9461

0.9250
(z) using excel function 15-02-2002 4.67 0.9050

‘=MMULT’ after marking the 15-08-2002 5.66 0.8841

area where want Excel to 15-02-2003 6.66 0.8633

present zero prices.

15-08-2003 7.64 0.8435

15-02-2004 8.64 0.8256

CNTRL+SHIFT+ENTER 15-08-2004 9.63 0.8079

• Maturity = (Maturity Date-

15-02-2005 10.63 0.7896

15-08-2005 11.61 0.7675

Settlement Date)/184 15-02-2006 12.61 0.7482

Using Matrix for Deriving Pure (Zero)
Yield Curve
• Step 5. Use Zero Prices to Maturity Zero Coupon Yield
Zero Coupon Yield

• Zero Yield =
0.70 2.26%
calculate Zero Yields. 1.69 2.19%
2.35%

2.30%
2.69 2.08%
2.25%
3.67 2.14%
4.67 2.16% 2.20%

• Zero Yield =
5.66 2.20% 2.15%

6.66 2.23% 2.10%

7.64 2.25% 2.05%
8.64 2.24% 2.00%
9.63 2.24% 1.95%
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00
10.63 2.25%
11.61 2.30%
12.61 2.33%
Par Bond Yield Curve (using spot
rates)
• A concept that is used in the industry is the par bond yield curve.
• It is the relationship between the yield to maturity and time to maturity of
bonds that sell at their par value.
Maturity Implied Zero Price Spot Rate of Interest
1 94.76190476 5.5276%
2 90.15514092 5.3185%
3 81.59421615 7.0155%

• We begin with a one –year bond issued to sell at par, what will be its
coupon? The present value of the coupon and the bullet payment must
equal 100,
• 100 = =  x1 = 5.53 (dollar coupon of the par bond)
Par Bond Yield Curve (using spot
rates)
• Two year bond
• 100 = = x2 = 5.325
• Three year bond 
• 100 = +  x3 = 6.910

Maturity Spot Rate of Interest(Y) Par Yield X

1 5.53% 5.53
2 5.32% 5.32
3 7.02% 6.91