31. Bootstrapping (LO1) One method used to obtain an estimate of the term structure of interest rates is called bootstrapping. Suppose you have a one-year zero coupon bond with a rate of r1 and a two-year bond with an annual coupon payment of C. To bootstrap the two-year rate, you can set up the following equation for the price (P) of the coupon bond:

P =

C 1 _1 _+_  _ r 1  + 

C 2  + Par value _________

(1 +  r 2 ) 2 Because you can observe all of the variables except r2, the spot rate for two years, you can solve for this interest rate. Suppose there is a zero coupon bond with one year to maturity that sells for

$949 and a two-year bond with a 7.5 percent coupon paid annually that sells for $1,020. What is the interest rate for two years? Suppose a bond with three years until maturity and an 8.5 percent annual coupon sells for $1,029. What is the interest rate for three years?