Zero-Coupon Swap
What Is a Zero-Coupon Swap?
A zero-coupon swap is an exchange of cash flows wherein the surge of floating interest-rate payments is made periodically, as it would be in a plain vanilla swap, however where the flood of fixed-rate payments is made as one lump-sum payment when the swap arrives at maturity, rather than periodically over the life of the swap.
Understanding a Zero-Coupon Swap
A zero-coupon swap is a derivative contract went into by two gatherings. One party makes floating payments which changes as indicated by the future publication of the interest rate index (for example LIBOR, EURIBOR, and so forth) whereupon the rate is benchmarked. The other party makes payments to the next in view of an agreed fixed interest rate.
The fixed interest rate is tied to a zero-coupon bond, or a bond that pays no interest for the life of the bond however is expected to make one single payment at maturity. In effect, the amount of the fixed-rate payment depends on the swap's zero-coupon rate. The bondholder on the finish of the fixed leg of a zero-coupon swap is responsible for making one payment at maturity, while the party on the finish of the floating leg must make periodic payments over the contract life of the swap. In any case, zero-coupon swaps can be structured with the goal 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 presented to a substantial level of default risk. The counterparty that doesn't receive payment for the rest of the agreement causes a greater credit risk than it would with a plain vanilla swap where both fixed and floating interest rate payments are agreed to be paid on certain dates after some time.
Esteeming a Zero-Coupon Swap
Esteeming a zero-coupon swap includes deciding the present value of the cash flows utilizing a spot rate (or zero-coupon rate). The spot rate is an interest rate that applies to a discount bond that pays no coupon and delivers just one cash flow at the maturity date. The current value of each fixed and floating leg will be resolved separately and summed together.
Since the fixed rate payments are known ahead of time, computing the current value of this leg is straightforward. To determine the current value of cash flows from the floating rate leg, the implied forward rate must be calculated first. The forward rates are normally implied from spot rates. The spot rates are derived from a spot curve which is worked from bootstrapping, a technique that shows a sequence of spot (or zero-coupon) rates that are reliable with the prices and yields on coupon bonds.
Varieties 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, lessening credit risk for the compensation floating party. Under a exchangeable zero-coupon swap, the party scheduled to receive a fixed sum at the maturity date can utilize a embedded option to transform the lump-sum payment into a series of fixed payments.
The floating payer will benefit from this structure assuming volatility declines and interest rates are moderately stable to declining. It is likewise workable for the floating-rate payments to be paid as a lump sum in a zero-coupon swap under an exchangeable zero-coupon swap.
Features
- Since the fixed leg is paid as a lump sum, esteeming a zero-coupon swap includes deciding the current value of those cash flows utilizing a zero-coupon bond's implied interest rate.
- The variable side of the swap actually makes normal payments, as they would in a plain vanilla swap.
- A zero-coupon swap includes the fixed side of the swap being paid in one lump sum when the contract arrives at maturity.
