Bootstrapping

Definition

Bootstrapping in plain English

Imagine you want to know the plain interest rate for money locked away for exactly 1 year, exactly 2 years, exactly 3 years, and so on — these are called "spot rates." The problem is that most bonds don't pay you in one clean lump; they dribble out small "coupon" payments every year plus a big payment at the end, so their price blends many years' rates together. Bootstrapping untangles this step by step: you first use a bond that pays off in 1 year to nail down the 1-year rate, then plug that into a 2-year bond to solve for the 2-year rate, then use both to crack the 3-year rate — each answer becoming a foothold for the next. It's like building a ladder where you can only reach the next rung by standing on the one you just built.

Learn these first

• Compounding
• Zero-coupon bond

Related Principles of Finance terms

• Accrued interest
• Allocation effect
• Basis
• Basis point
• Benchmark
• Bond-equivalent yield (BEY)
• Callable bond
• Clean price
• Comparable company analysis (comps)
• Control premium