Deriving Zero-Coupon Rates: Alternatives to Orthodoxy

Abstract

The bootstrapping method for deriving zero-coupon rates from par yield curves implicitly assumes a specific forecast of prospective interest rate changes. In the event that market conditions reflect this standard methodology but, at the same time, individual practitioners reject the implicit forecast, contrarian opportunities will be present. Additionally, to the extent that zero-coupon discount rates are based on unacceptable assumptions, any subsequent present valuation calculation using these rates would be suspect. We propose two methodologies whereby any explicit interest rate forecast may be used for determining zero-coupon interest rates. “Backsliding” calculates zero-coupon returns by assuming interim interest cash flows are always rolled over into the longest maturity coupon-bearing instruments available; “frontsliding” requires rolling these cash flows over into the shortest maturity vehicles. The choice of methodology should be driven by rate forecasts, as well as whether the objective is for f...