What Is a Zero-Coupon Swap?

A zero-coupon swap is an exchange of cash flows in which the stream of floating interest-rate payments is made periodically, as it would be in a plain vanilla swap, but where the stream of fixed-rate payments is made as one lump-sum pa♈yment at the time when the swap reaches maturity, instead of periodically 🌌over the life of the swap.

Understanding a Zero-Coupon Swap

A zero-coupon swap is a 澳洲幸运5官方开奖结果体彩网:derivative contract entered into by two parties. One party makes floating payments which changes according to the future publication of the 澳洲幸运5官方开奖结果体彩网:interest rate index (e.g. LIBOR, EURIBOR, etc.) upon which the rate is benchmarked. The other party makes payments to the other based on an agreeಌd fixed interest rate.

The fixed interest rate is tied to a 澳洲幸运5官方开奖结果体彩网:zero-coupon bond, or a bond that pays no interest for the life of the bond but is expected to make one single payment at maturity. In effect, the amount of the fixed-rate payment is based on the swap's zero-coupon rate. The bondholder on the end of the fixed leg of a zero-coupon swap is responsible for making one payment at matur༒ity, while the party on the end of the floating leg must make periodic payments over the contract life of the swap. However, zero-coupon swaps can be structured so that both floating and fixed-rate payments are paid as a lump sum.

Since there’s a mismatch in the frequency of payments, the floating party is exposed to a substantial level of 澳洲幸运5官方开奖结果体彩网:default risk. The counterparty that does not receive payment until the end of the agreement incurs a greater 澳洲幸运5官方开奖结果体彩网:credit risk than it would with a plain vanilla swap in which both fixed and float🥃ing interest rate payments are agreed to be paid on certain dates over time෴.

Valuing a Zero-Coupon Swap

Valuing a zero-coupon swap involves determining the 澳洲幸运5官方开奖结果体彩网:present value of the cash flows using a 澳洲幸运5官方开奖结果体彩网:spot rate (or zero-coupon rate). The spot rate is an interest rate that applies to a 澳洲幸运5官方开奖结果体彩网:discount bond that pays💮 no coupon and produces just one cash flow at the maturity date. The present value of each fixed and floating leg will be determined separately and summed together.

Since the fixed rate payments are known ahead of time, calculating the present value of this leg is straightforward. To derive the present value of cash flows from the floating rate leg, the implied 澳洲幸运5官方开奖结果体彩网:forward rate must be calculated first. The forward rates are usually implied from spot rates. The spot rates are derived from a 澳洲幸运5官方开奖结果体彩网:spot curve which is built from 澳洲幸运5官方开奖结果体彩网:bootstrapping, a technique that shows a sequence of spot (or zero-coupon) rates that are consistent with the prices and yields on coupon b✱onds.

Variations of the zero-coupon swap exist to meet different investment needs. A reverse zero-coupon swap pays the fixed lump-sum payment upfront when the contract is initiated, reducing credit risk for the pay-floating party. Under an exchangeable zero-coupon swap, the party scheduled to receive a fixed sum at the maturity date can use an 澳洲幸运5官方开奖结果体彩网:embedded option to🌌 turn the lump-sum payment into a𝓡 series of fixed payments.

The floating payer will benefit from this structure if volatility de🧔clines and interest rates are relativel▨y stable to declining. It is also possible for the floating-rate payments to be paid as a lump sum in a zero-coupon swap under an exchangeable zero-coupon swap.