In a zero coupon swap, the floating interest rate is exchanged for the fixed interest rate. The floating interest rate is paid on a periodic basis, whereas a fixed interest rate is paid in a lump sum figure. The fixed amount is generally paid after the completion of the contract or on the maturity of the contract.
When the payment of the fixed interest rate is made at the beginning of the contract, then it is termed as a reverse zero coupon interest rate swap. When the payment is due till the contract maturity, higher credit risk is associated with it due to of the time value of money. In reverse zero coupon swap, the credit risk is not present.
Moreover, zero coupon swap can be structured in such a manner that the payment of both fixed and floating interest rates can be made in a lump sum amount. (SOURCE: https://www.moneywords.com/zero-coupon-swap)
Two parties enter a zero coupon swap which is a derivative contract. One of the parties agrees to make a floating interest payment that is, the payment will change in accordance to the interest rate index, which includes benchmarks like LIBOR, EURIBOR and so on. The other party pays a fixed amount of interest rate which is agreed upon by both parties.
In the zero coupon bond, the interest payment is not made throughout the life of the bond but a single fixed interest rate payment is made at the maturity of the bond. The value of the fixed payment is dependent upon the interest rate on the zero coupon bond.
The bondholder who is responsible for making a fixed-rate payment makes the whole payment at the end of the contract. On other hand, the bondholder who is responsible for making floating-rate payments, makes the payment on a periodic basis, till the contract matures.
Zero coupon swaps provide the scope of structuring the derivative contract in a manner that both parties make a single lump sum payment.
The frequency of floating payments is different from the fixed interest rate payment. The party making floating interest payment is exposed to the default risk. The other party, which does not receive the payment till the end of maturity is exposed to the credit risk. In case both parties make payment on regular intervals, or the difference is adjusted on a daily basis, then it is just a plain vanilla swap.
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While calculating the value of a zero coupon swap, firstly present value of the cash flow is ascertained by utilising the zero coupon rate. Zero coupon rate stands for that interest rate which is associated with the zero coupon bond. A zero coupon bond does not make payment of coupons but only one cash flow is generated at the end of the contract. The present value of both floating and fixed interest payments will be calculated and then it will be summed together.
The fixed-rate payment is known before entering the zero coupon swap contract; therefore, its calculation is straightforward. The calculation of the present value for the floating rate cash flow is a little complicated. The implied forward rate calculations are made first which are implied from the spot rates. Spot curves are used for deriving the value of spot rates. Spot curves are built using the bootstrapping technique. Bootstrapping technique creates a sequence of spot rates that are consistent with the yields and prices of coupon bonds.
An investor can take advantage of the interest rate variations in the zero coupon swaps and meet their investment requirements. In reverse zero coupon swap, the fixed interest payment is made while entering the contract which reduces the credit risk faced by the party paying the floating interest rate.
In an Exchangeable zero coupon swap, the party which receives the fixed amount at the end of the contract can utilise an embedded option, in which the party will receive the fixed lump sum payment in the form of a series of fixed payments. Moreover, under the exchangeable zero coupon swap, the floating interest ratepayer can opt for the option in which they can make payment in a lumpsum amount and not periodically.
In case the benchmark interest rate declines in the market, then the floating interest ratepayer is benefited and if the index increases then the party making the fixed payment is benefited.
In a zero-coupon inflation swap, the fixed-rate payment on an amount is exchanged for a payment based on the existing inflation rate. It is a derivative contract that exposes both parties to the fluctuations in the purchasing power.
Another term for zero coupon inflation swap is a breakeven inflation swap.
Chiefly, by utilising the ZCIS, the party can transfer the inflation risk to another party in exchange for a fixed amount. One income stream is tied to the inflation rate and the other income stream is tied up with the fixed rate of interest. The payoff is dependent upon the inflation rate. Also, the ZCIS contract can be used to hedge against inflation.
Generally, the payment is made at the maturity of the contract, but the party can sell the contract in the over-the-counter market before the maturity.
Like zero coupon swaps, the fixed payment is done at the maturity of the contract in a lump sum amount. The variation in the ZCIS allows both parties to make payments in a lump sum amount if the inflation rate is known.