Zero Coupon Swap

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Zero Coupon Swap

A zero-coupon swap is a type of interest rate swap where one party agrees to make a one-time payment of a predetermined amount to the other party in exchange for a series of future floating rate payments. This type of swap is called a “zero coupon” because no interest payments are made during the life of the swap.

In a zero-coupon swap, the party making the one-time payment is usually referred to as the “fixed-rate receiver,” while the party receiving the future floating rate payments is referred to as the “floating-rate receiver.” The fixed-rate receiver agrees to pay a fixed interest rate, while the floating-rate receiver agrees to pay a floating interest rate, usually based on a benchmark rate such as LIBOR (London Interbank Offered Rate).

The fixed-rate receiver makes the one-time payment at the beginning of the swap, which is usually equal to the present value of the future floating rate payments. The floating-rate payments are then made periodically over the life of the swap, usually based on a notional amount that is agreed upon by the parties.

Zero-coupon swaps are often used by corporations or other entities to hedge against interest rate risk. For example, a company that has issued bonds with fixed interest payments may want to convert these fixed payments into floating rate payments to better match its cash flows or reduce its exposure to interest rate fluctuations. A zero-coupon swap can help achieve this goal.

Another use of zero-coupon swaps is in creating synthetic zero-coupon bonds. A synthetic zero-coupon bond is a bond that does not pay periodic interest payments but instead makes a single payment at maturity. By using a zero-coupon swap, investors can effectively create a synthetic zero-coupon bond by converting a bond that pays periodic interest payments into a bond that pays a single payment at maturity. This can be useful for investors who prefer a lump-sum payment at maturity rather than receiving periodic interest payments.

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