The process involves deriving a yield curve that reflects yields for zero-coupon bonds at various maturities. These yields, often termed zero-coupon yields or spot rates, represent the return an investor would receive if they held a bond until maturity, receiving only a single payment at the end of the term. The bootstrapping method is a common technique. It starts with the shortest maturity bond and iteratively solves for the implied zero-coupon yield, using the known prices and coupon payments of the bonds. For instance, the yield of a six-month Treasury bill directly provides the six-month spot rate. Subsequently, the price and coupon of a one-year Treasury bond, along with the already determined six-month spot rate, are used to solve for the one-year spot rate. This process is repeated for bonds with longer maturities.
Understanding the yield curve derived from government securities is essential for fixed income analysis. Spot rates are critical for pricing other fixed-income instruments, valuing future cash flows, and evaluating the relative value of different securities. They serve as a benchmark for corporate bonds and other debt instruments. Historically, the accurate determination of spot rates has aided in more precise portfolio management and risk assessment, contributing to improved decision-making in investment strategies.
