How To Construct and Bootstrap Yield Curve: David Lee

How to Construct and
Bootstrap Yield Curve
David Lee
FinPricing
https://finpricing.com/curveVolList.html
Yield Curve
The term structure of interest rates, also known as yield

curve, is defined as the relationship between the yield-to-
maturity on a zero coupon bond and the bond’s maturity. Zero
yield curves play an essential role in the valuation of all
financial products.
Yield curves can be derived from government bonds or
LIBOR/swap instruments. The LIBOR/swap term structure offers
several advantages over government curves, and is a robust
tool for pricing and hedging financial products. Correlations
among governments and other fixed-income products have
declined, making the swap term structure a more efficient
hedging and pricing vehicle.
Yield Curve
Summary
▪ Yield Curve Introduction
▪ Yield Curve Construction and Bootstrapping Overview
▪ Interpolation
▪ Optimization
Yield Curve
Yield Curve Introduction

▪ The term structure of interest rates, also known as yield curve, is
defined as the relationship between the yield-to-maturity on a
zero coupon bond and the bond’s maturity.
▪ Zero yield curves play an essential role in the valuation of all
financial products.
▪ Yield curves can be derived from government bonds or
LIBOR/swap instruments.
▪ The LIBOR/swap term structure offers several advantages over
government curves, and is a robust tool for pricing and hedging
financial products.
Yield Curve
Yield Curve Introduction (Cont)

▪ Correlations among governments and other fixed-income
products have declined, making the swap term structure a more
efficient hedging and pricing vehicle.
▪ With the supply of government issues declining, LIBOR/swap
markets are more liquid and efficient than government debt
markets.
▪ LIBOR curves constructed from the most liquid interest rate
instruments have become the standard funding curves in the
market.
▪ The 3 month LIBOR curve is the base yield curve in the market.
Yield Curve

▪ The term structure of zero rates is constructed from a set of
market quotes of some liquid market instruments such as short
term cash instruments, middle term futures or forward rate
agreement (FRA), long term swaps and spreads.
▪ Prior to the 2007 financial crisis, financial institutions performed
valuation and risk management of any interest rate derivative on a
given currency using a single-curve approach. This approach
consisted of building a unique curve and using it for both
discounting and forecasting cashflows.
Yield Curve

▪ However, after the financial crisis, basis swap spreads were no
longer negligible and the market was characterized by a sort of
segmentation. Consequently, market practitioners started to use a
new valuation approach referred to as multicurve approach, which
is characterized by a unique discounting curve and multiple
forecasting curves
▪ The current methodology in capital markets for marking to market
securities and derivatives is to estimate and discount future cash
flows using rates derived from the appropriate term structure. The
yield term structure is increasingly used as the foundation for
deriving relative term structures and as a benchmark for pricing
and hedging.
Yield Curve
Yield Curve Construction Overview

▪ Yield curves are derived or bootstrapped from observed market
instruments that represent the most liquid and dominant interest
rate products for certain time horizons.
▪ Normally the curve is divided into three parts. The short end of
the term structure is determined using LIBOR rates. The middle
part of the curve is constructed using Eurodollar futures or
forward rate agreements (FRA). The far end is derived using mid
swap rates.
▪ The objective of the bootstrap algorithm is to find the zero yield or
discount factor for each maturity point and cash flow date
sequentially so that all curve instruments can be priced back to
the market quotes.
Yield Curve
Yield Curve Construction Overview (Cont)

▪ All bootstrapping methods build up the term structure from
shorter maturities to longer ones.
▪ One needs to have valuation models for each instrument.
▪ Given a Future price, the yield or zero rate can be directly
calculated as
100 − 𝑃 𝐶𝑣𝑥𝐴𝑑𝑗
𝑟= −
100 10000
where
P the quoted interest rate Future price
r the derived yield or zero rate
CvxAdj the Future convexity adjustment quoted in basis points
(bps)
Yield Curve

▪ The swap pricing model is introduced as
http://www.finpricing.com/lib/IrSwap.html
▪ Assuming that we have all yields up to 4 years and now need to
derive up to 5 years.
• Let x be the yield at 5 years.
• Use an interpolation methd to get yields at 4.25, 4.5 and 4.75 years
as Ax, Bx, Cx,Dx.
• Given the 5 year market swap rate, we can use a root-finding
algorithm to solve the x that makes the value of the 5 year inception
swap equal to zero.
• Therefore we get all yields or equivalent discount factors up to 5
years
Yield Curve

▪ Repeat the above procedure till the longest swap maturity.
▪ There are two keys in yield curve construction: interpolation and

root finding.
Yield Curve
Interpolation
▪ Most popular interpolation algorithms in curve bootstrapping are
linear, log-linear and cubic spline.
▪ The selected interpolation rule can be applied to either zero rates
or discount factors.
▪ Some critics argue that some of these simple interpolations
cannot generate smooth forward rates and the others may be able
to produce smooth forward rates but fail to match the market
quotes.
▪ Also they cannot guarantee the continuity and positivity of
forward rates.
Yield Curve
Interpolation (Cont)
▪ The monotone convex interpolation is more rigorous. It meets the
following essential criteria:
• Replicate the quotes of all input underlying instruments.
• Guarantee the positivity of the implied forward rates
• Produce smooth forward curves.
▪ Although the monotone convex interpolation rule sounds almost

perfectly, it is not very popular with practitioners.
Yield Curve
Optimization
▪ As described above, the bootstrapping process needs to solve a
yield using a root finding algorithm.
▪ In other words, it needs an optimization solution to match the

prices of curve-generated instruments to their market quotes.
▪ FinPricing employs the Levenberg-Marquardt algorithm for root

finding, which is very common in curve construction.
▪ Another popular algorithm is the Excel Solver, especially in Excel

application.
Thank You
You can find more details at

https://finpricing.com/lib/IrCurve.html

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How to Construct and

Bootstrap Yield Curve

The term structure of interest rates, also known as yield

▪ Yield Curve Construction and Bootstrapping Overview

Yield Curve Introduction

Yield Curve Introduction (Cont)

Yield Curve Introduction (Cont)

Yield Curve Introduction (Cont)

Yield Curve Construction Overview

Yield Curve Construction Overview (Cont)

Yield Curve Construction Overview (Cont)

Yield Curve Construction Overview (Cont)

▪ There are two keys in yield curve construction: interpolation and

• Guarantee the positivity of the implied forward rates

• Produce smooth forward curves.

▪ Although the monotone convex interpolation rule sounds almost

▪ In other words, it needs an optimization solution to match the

▪ FinPricing employs the Levenberg-Marquardt algorithm for root

▪ Another popular algorithm is the Excel Solver, especially in Excel

You can find more details at

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