Last month, we explained how to calculate a series of zero-coupon rates from a number of coupon-paying bonds with different maturities – using a technique called ‘bootstrapping’. We calculated the zerocoupon rates for two and three year bonds. Data for a four year bond have been added to this table and a yield curve has been drawn.

This ‘curve’ can then be used to compare the yield on bonds of different maturities.

Challenges to be overcome

Despite the ‘bootstrapping’ technique being straightforward and applicable to a variety of different instruments, in real-life it can be difficult to calculate a complete yield curve using this technique. This is due to three main reasons:

1. Availability of instruments.

   In our illustration, we have assumed that instruments with the desired maturities are available to create a full yield curve. In practice, it can be difficult to identify instruments with these maturities.

2. Drawing curves can be difficult.

   As a result, investors need to draw a yield curve on the basis of the instruments which are available. They can calculate a series of interim points, but there may not be a clear and smooth relationship between those points. This makes calculating the exact shape of the yield curve more difficult.

3. Market imperfections.

   This method assumes the bonds are priced accurately in the market. Despite prices being more transparent these days, there is still likely to be a difference between the prices and yields on different instruments.