Financial Simulation Modeling in Excel

BOND TERM STRUCTURE AND BOOTSTRAPPING

For more frequently traded CDS where multiple tenors are available, “bootstrapping” is done to calculate the implied default probability for each individual year. This process can be completed using bond prices as well. Bonds, however, have additional layers of complexity, due to their variety. Fixed/floating differences, optionality, different covenants, and different payment schedules all make modeling bonds more difficult than CDS. However, for this analysis we will consider only the risk of default in our calculations.

Bootstrapping, at least as it is used in quantitative finance, is the term for creating a term-structure from a set of traded securities or derivates. While we can obtain reasonable default probability estimates from markets with only a single tenor security trading, we want to take advantage of the additional information that is available when a number of securities or derivates are in the market. The concept requires us to start with the shortest-term debt we have liquid prices for. With this first security (let's assume it's a one-year bond), we find the default probability as we did with the CDS (the only difference being that we need to subtract out the risk-free rate).

After we have the probabilities of default determined for the first security, we move on to the next security (let's assume it's a three-year bond). We could determine default probabilities in the same fashion; however, we already have specific data for ...