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Application Concept: Term Structure

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Textbook ELI8 Bootstrapping Bootstrap Coupon Bond

Term Structure of Interest Rates: Exploring the Yield Curve, Limitations for Bond Pricing, and Bootstrapping Techniques

Alright, imagine you have a piggy bank where you save money. The term structure of interest rates is like understanding how much extra money you get (interest) based on how long you leave your money in the piggy bank (maturity). The "yield curve" is like drawing a line to show how much extra money you'd get for different time periods.

Now, sometimes this line can have different shapes:

  1. Normal Curve: Imagine the line going up. This means if you leave your money for a longer time, you get more extra money. This usually happens when people think the economy is doing well.

  2. Inverted Curve: Picture the line going down. This is like a warning sign. If short-term rewards (interest) are higher than long-term ones, it might mean the economy is going to have problems.

  3. Flat Curve: Envision a straight line. This suggests people are not sure about the future. They're unsure if they should expect more or less extra money for different time periods.

Now, the tricky part is using this line to figure out how much your piggy bank money is worth (bond pricing). The line doesn't always tell the whole story because it depends on what people expect to happen in the future.

Also, bonds are like special piggy banks with extra features, and their value is influenced by things like how safe they are or if you can get your money back easily. The yield curve doesn't consider these extra factors.

To solve this, people use a method called "bootstrapping." It's like a puzzle where you figure out how much extra money you get for each time period by looking at the prices of different bonds. This helps make a more accurate line that considers all the details.

Good Stuff about Bootstrapping:

  1. It helps create a more accurate line showing how much extra money you get for different times.
  2. It helps figure out exactly how much your special piggy bank (bond) is worth, considering all the special features.

Not-So-Good Stuff about Bootstrapping:

  1. It needs lots of accurate information about different types of bonds, which might not always be available.
  2. Sometimes, the method makes assumptions that might not be true, and this could affect how accurate the final line is.

In the end, understanding all this helps people who are into bonds make smart decisions about how much their piggy bank money is worth and how safe it is to keep it in certain types of piggy banks.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.