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Explain how bootstrapping extracts zero-coupon (spot) rates from the par curve

CFA® Level II · Fixed Income · The Term Structure and Interest Rate Dynamics · L2.FI.1.b

The idea

Bootstrapping works along the par curve one maturity at a time. The one-year spot rate equals the one-year par yield because there is only one cash flow. For two years, a par bond priced at 100 pays its coupon at year one and coupon plus principal at year two; subtract the year-one coupon discounted at the known one-year spot rate, and the remainder must be the present value of the final payment, which gives the two-year spot rate. Each later spot rate uses all earlier ones. On a rising curve, spot rates end up above par yields. Two traps: forgetting to strip out the earlier coupons, and discounting them with the wrong exponent.

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