X6.4
Hi Jayant
This is called the "bootstrapping" technique. If you go on to study ST5 you will learn much more about it. If you can do this example, with just 3 cashflows, that should be more than enough knowledge of the technique for CA1.
The idea is that you match the cashflows, starting with the last one and work backwards. You do it this way so that you're investing in bonds of the correct term. Assuming the bond redeems at par, you need to use the nominal value not the market value.
This is because it's the final cashflow you're trying to match each time, whereas the market value incorporates all cashflows.
And then if you keep doing the same, allowing for the coupons you will get on the longer bonds, and keep working forwards to the 1 year bond, there is a single cashflow at time 1 so that is then easy to match too.
Otherwise it would be difficult to know what combination of coupons on earlier bonds + redemption payment you'd need.
Hope this helps
Best wishes
Stuart
Stuart Underwood
ActEd Tutor
PS This question would not be my priority for last-minute crammers, and I wish you all the best of luck!
Last edited by a moderator: Apr 19, 2015