What Is a Zero-Coupon Swap?
Let me explain what a zero-coupon swap is. It's an exchange of cash flows where you have periodic floating interest-rate payments, just like in a plain vanilla swap, but the fixed-rate payments come as one big lump sum at maturity instead of spreading them out over time.
Key Takeaways
- A zero-coupon swap has the fixed side paid in one lump sum at contract maturity.
- The variable side still involves regular payments, similar to a plain vanilla swap.
- Valuing it means finding the present value of cash flows using a zero-coupon bond's implied interest rate.
Understanding a Zero-Coupon Swap
You enter a zero-coupon swap as a derivative contract with another party. One side makes floating payments that adjust based on future interest rate indexes like LIBOR or EURIBOR. The other side pays based on a fixed interest rate.
This fixed rate ties to a zero-coupon bond, which doesn't pay interest during its life but gives one payment at maturity. Essentially, the fixed payment in the swap uses the swap's zero-coupon rate. If you're on the fixed leg, you make one payment at maturity, while the floating leg pays periodically throughout the swap's life. But you can structure these swaps so both sides pay lump sums.
There's a payment frequency mismatch, so the floating party faces substantial default risk. If you're not getting paid until the end, your credit risk is higher than in a vanilla swap where payments happen on set dates over time.
Valuing a Zero-Coupon Swap
To value a zero-coupon swap, you determine the present value of cash flows using a spot rate, which is the interest rate for a discount bond that pays nothing until one cash flow at maturity. You calculate the present value for each leg separately and add them up.
The fixed rate payments are known in advance, so their present value is straightforward. For the floating leg, you first calculate the implied forward rate from spot rates. Spot rates come from a spot curve built via bootstrapping, which creates consistent zero-coupon rates from coupon bond prices and yields.
Variations of Zero-Coupon Swaps
There are variations to fit different needs. A reverse zero-coupon swap pays the fixed lump sum upfront at initiation, cutting credit risk for the floating payer. In an exchangeable zero-coupon swap, the party due to receive the fixed sum at maturity can use an option to convert it into periodic fixed payments.
The floating payer gains if volatility drops and rates stay stable or decline. You can also set floating payments as a lump sum in an exchangeable zero-coupon swap.
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