Pricing a Bond: Replication vs Bootstrapping
1. Context
In this short video, we take a comparative look at two valuation approaches for finding fair value of a fixed income instrument (say, a regular bond), when fair prices of other instruments are served to us. These two approaches are namely, the Replicating Portfolio (that invokes the ‘Law of One Price’) and Bootstrapping approach that recovers from observed prices, the embedded values of spot rates or discount factors. The prescribed reading illustrates the equivalence via a mathematical proof. Herein, we try and explore it via a simple pricing example. The details of the reading in which this topic appears are given below:
| Area | Valuation and Risk Models |
| Reading | Prices, Discount Factors and Arbitrage |
| Reference | Bruce Tuckman, Chapter 1. Prices, Discount Factors, and Arbitrage In Fixed Income Securities, 3rd Edition, (Hoboken, NJ: John Wiley & Sons, 2011). |