Building discount factors from market instruments
Question
What does bootstrapping a yield curve with discount factors involve?
Short answer
Extracting discount factors maturity by maturity from instruments ordered by maturity. Start with the shortest instruments (deposits) to get the first discount factors, then for each longer bond or swap the only unknown is the factor at its final date, since earlier cash flows use factors already found; solve for it and continue. Interpolation fills gaps between maturities, and the curve exactly reprices every input.
Adapted from Wilmott, Frequently Asked Questions in Quantitative Finance, FAQ 38, p.179; question and answer rewritten by SelfMadeQuant.com.
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