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 payment at the time when the swap reaches maturity, instead of periodically over the life of the swap.
Key Takeaways
- A zero-coupon swap involves the fixed side of the swap being paid in one lump sum when the contract reaches maturity.
- The variable side of the swap still makes regular payments, as they would in a plain vanilla swap.
- Because the fixed leg is paid as a lump sum, valuing a zero-coupon swap involves determining the present value of those cash flows using a zero-coupon bond's implied interest rate.
Understanding a Zero-Coupon Swap
A zero-coupon swap is a derivative contract entered into by two parties. One party makes floating payments which changes according to the future publication of the 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 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 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 maturity, 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 default risk. The counterparty that does not receive payment until the end of the agreement incurs a greater credit risk than it would with a plain vanilla swap in which both fixed and floating 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 present value of the cash flows using 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 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 forward rate must be calculated first. The forward rates are usually implied from spot rates. The spot rates are derived from a spot curve which is built from bootstrapping, a technique that shows a sequence of spot (or zero-coupon) rates that are consistent with the prices and yields on coupon bonds.
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 embedded option to turn the lump-sum payment into a series of fixed payments.
The floating payer will benefit from this structure if volatility declines and interest rates are relatively 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.
FAQs
A zero coupon inflation swap is where a debt instrument with an inflation-adjusting interest payment is sold to another investor for a fixed amount, delivered at maturity. Investors use it as a way to hedge against inflation.
How does a zero-coupon bond work? ›
Zeros, as they are sometimes called, are bonds that pay no coupon or interest payment. With a zero, instead of getting interest payments, you buy the bond at a discount from the face value of the bond and are paid the face amount when the bond matures.
How to calculate zero-coupon rate? ›
The basic method for calculating a zero coupon bond's price is a simplification of the present value (PV) formula. The formula is price = M / (1 + i)^n where: M = maturity value or face value. i = required interest yield divided by 2.
Are zero coupons risky? ›
Because of their sensitivity to interest rates, zero-coupon Treasury bonds have incredibly high interest rate risk. Treasury zeros fall significantly if the Fed raises interest rates. They also have no interest payments to cushion a fall. Zero-coupon U.S. Treasury bonds have a poor risk-return profile when held alone.
Do you pay taxes on zero-coupon bonds? ›
Zero coupon bonds are subject to capital gains taxes and some zero coupon bonds require investors to pay taxes on the imputed interest that accrues on the bonds each year, even though that interest is not paid until maturity (as part of the bonds' face-value).
Why do people buy zero coupons? ›
The Zero Coupon bonds eliminate the reinvestment risk. Zero-Coupon bonds do not let any periodic coupon payments, and hence a fixed interest on Zero Coupon bonds is guaranteed. Fixed returns: The Zero Coupon bond is a perfect choice for those who prefer long-term investment and earn a lump sum.
How to make money with a zero-coupon bond? ›
Zero-coupon bonds are issued at a deep discount and repay the par value at maturity. The difference between the purchase price and the par value represents the investor's return. The payment received by the investor is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield.
Can a zero-coupon bond sell at a discount? ›
As a zero-coupon bond does not pay periodic coupons, the bond trades at a discount to its face value.
How often do zero-coupon bonds pay interest? ›
Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond "matures" or comes due.
Who pays the coupon on a bond? ›
Upon the issuance of the bond, a coupon rate on the bond's face value is specified. The issuer of the bond agrees to make annual or semi-annual interest payments equal to the coupon rate to investors. These payments are made until the bond's maturity.
These are special types of bonds issued by the Central government specifically to a particular institution. Only those banks, whosoever is specified, can invest in them, nobody else. It is not tradable, it is not transferable.
What is the difference between zero-coupon bond and discount bond? ›
Zero coupon bonds are priced by discounting the face value to its present value using the prevailing interest rate and time to maturity. Similarly, deep discount bonds are priced by considering any periodic interest payments along with the face value.
How are investors in zero-coupon bonds compensated? ›
A regular bond pays interest to bondholders, while a zero-coupon bond does not issue such interest payments. Instead, zero-coupon bondholders merely receive the face value of the bond when it reaches maturity.
Do zero-coupon bonds trade flat? ›
Also, zero coupon bonds don't pay semi-annual interest, so there is no accrued interest to be paid. These bonds trade flat, meaning they trade without accrued interest.
Can a zero-coupon bond sell at a premium? ›
If the needed rate of return is negative, a zero-coupon bond can only sell at a premium.
How does swap pricing work? ›
A swap is priced by solving for the par swap rate, a fixed rate that sets the present value of all future expected floating cash flows equal to the present value of all future fixed cash flows. The value of a swap at inception is zero (ignoring transaction and counterparty credit costs).
What is the difference between zero coupon swap and FRA? ›
So the two main differences are (a) a zero coupon swap can contain multiple payment periods, a FRA only has one (b) the FRA payment happens at the start of the reference period (but is discounted so that it is equivalent to a payment at the end) and the ZCS payment happens at the end of the reference period ( ...
How does swap financing work? ›
What Is a Swap? A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount related to a loan or bond, although the security can be almost anything.
How do swap deals work? ›
A swap is an agreement for a financial exchange in which one of the two parties promises to make, with an established frequency, a series of payments, in exchange for receiving another set of payments from the other party. These flows normally respond to interest payments based on the nominal amount of the swap.
