What is the purpose of bootstrapping in yield curve construction?

• A. Bootstrapping builds a zero-coupon yield curve from observed coupon-bearing instruments by sequentially solving for zero-coupon yields.
• B. Bootstrapping a mortgage to compute payments.
• C. Sorting yields by maturity.
• D. Calibrating to index options.

Answer: (A)

Bootstrapping constructs a zero-coupon yield curve from the prices of coupon-bearing instruments by solving for the implied zero-coupon yields step by step. The idea is to obtain the exact discount factors for each maturity, ensuring no-arbitrage consistency with observed market prices. Start with the shortest maturities, where the cash flows translate directly into a zero yield. Then move to longer maturities, using the discount factors determined earlier to strip out earlier cash flows and solve for the next zero-coupon yield so the instrument’s price matches its market price. Repeating this process yields a complete zero-coupon curve that can be used to discount any future cash flow. This is not about mortgage payments, sorting yields, or calibrating to options; it specifically derives the pure, maturity-specific spot rates from coupon-bearing prices.