Zero Coupon

Swap
 Swaps are financial derivatives that involve two
parties agreeing to swap a series of cash flows
over a set period of time. When it come to
establishing and structuring contracts based on
mutual agreement, swaps offer a lot of freedom.
As a result of this wersatility, there are numerous
swap variations, each with its own purpose. The
zero-coupon swap is one of them.

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Zero Coupon Swap
✗ It is a cash-flow exchange in which the stream of floating
interest-rate payments is made frequently, as in a regular swap,
but the stream of fixed-rate payments is made as a single lump-
sum payment when the swap matures, rather than periodically
over the swap's duration.

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 Understanding a Zero
✗
Coupon Swap
A zero-coupon swap is a derivative contract that the two parties enter into. One party
pays floating payments that fluctuate based on the future publication of the interest rate
index (e.g., LIBOR, EURIBOR, etc.) used to benchmark the rate. THe other party makes
payments to the other based on a set interest rate that has been agreed upon.

✗ The fixed rate is linked to a zero-coupon bond, which pays no interest for the duration
of the bond but is projected to make a single payment at maturity. In effect, the fixed-
rate payments amount is determined by the swap's zero-coupon rate. The bondholder on
the fixed leg of a zero-coupon swap is responsible for paying a single payment at
maturity, whereas the party on the floating leg is responsible for making periodic
payments over the swap's contract life. Zero-coupon swaps, on the other hand, can be
structured in such a way that both variable and fixed-rate payments are made in one
lump sum

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 Valuing a Zero-Coupon Swap

✗ When valuing a zero-coupon swap, the present value of the cash

flows is calculated using a spot rate (or zero-coupon rate). The spot
rate is the interest rate that applies to a discount bond with no
coupon payments and only one cash flow at maturity. Each fixed and
floating leg's current value will be determined separately and then
added together.
.

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 Valuing a Zero-Coupon Swap
✗ The present value of this leg is simple to calculate because the fixed
rate payment are known ahead of time. The implied forward rate
must be computed first in order to calculate the present value of cash
flows from the floating rate leg. In most cases, forward rates are
derived from spot rates. The spot rates are calculated using a spot
curve created using bootstrapping, a process that generates a series
of spot (or zero-coupon) rates that are consistent with coupon bond
prices and yields.

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 Valuing a Zero-Coupon Swap
✗ There are several variations of the zero-coupon swap to fit various
investing needs. WHen a reverse zero-coupon swap is initiated, the
fixed lump-sum payment is made ahead, minimizing credit risk for
the pay-floating party. An exchangeable zero-coupon swap allows
the party receiving a lump-sum payment at maturity to exercise an
embedded option to convert the payment into a series of fixed
payments.

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Valuing a Zero-Coupon Swap

✗ If volatility falls and interest rates remain stable or fall, the floating
player will benefit from this structure. Under an exchangeable zero-
coupon swap, the floating-rate payments can also be paid as a lump
sum in a zero-coupon swap.

References:
https://www.investopedia.com/terms/z/zero-coupon-swap.asp

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Zero Coupon Inflation Swap
✗ It is a type of derivative in which a fixed-rate payment on a notional
amount is swapped for an inflation-indexed payment. It is a cash
flow exchange that allows investors to decrease or enchance their
exposure to fluctuations in money's purchasing power.

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Understanding a Zero Coupon
Inflation Swap (ZCIS)
✗ An inflation swap is a contract that allows one party to transfer
inflation risk to another by exchanging fixed cash flows. An revenue
stream connected to the rate of inflation is exchanged for an income
stream with a fixed interest rate in a ZCIS, which is the most basic
type of inflation derivative. During the life of the investment, a zero-
coupon security does not pay periodic interest. Instead, the holder of
the security receives a lump sum payment on the maturity date.

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 Computing the Price of a Zero-Coupon
Inflation Swap (ZCIS)
The inflation buyer pays a fixed amount, known as the fixed leg.

This is:
Fixed Leg = A * [(1 + r)t – 1]

The inflation seller pays an amount given by the change in the inflation index, known as the inflation leg.

This is:
Inflation Leg = A * [(IE ÷ IS) – 1]
where:
A = Reference notional of the swap
r = The fixed rate
t = The number of years
IE = Inflation index at the end (maturity) date
IS = Inflation index at the start date

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 Example of a Zero-Coupon Inflation
Swap (ZCIS)
Assume that two parties enter into a five-year ZCIS with a notional amount of $100 million, a
2.4% fixed rate, and the agreed-upon inflation index, such as the Consumer Price Index (CPI),
at 2.0% when the swap is agreed upon. At maturity, the inflation index is at 2.5%.

Fixed Leg = $100,000,000 * [(1.024)5 – 1)] = $100,000,000 * [1.1258999 – 1]

= $12,589,990.68

Inflation Leg = $100,000,000 * [(0.025 ÷ 0.020) – 1] = $100,000,000 * [1.25 – 1]

= $25,000,000.00

Since the compounded inflation rate rose above 2.4%, the inflation buyer
profited; otherwise, the inflation seller would have profited.

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 Benefits of Inflation Swaps
✗ An inflation swap has the advantage of giving an analyst a
pretty precise estimate of what the market regards to be the
'break-even' inflation rate. It works in a similar fashion to
how a market determines the price of any product, namely the
agreement between a buyer and a seller ( demand and
supply ) to transact at a defined rate. The given rate in this
situation is the expected rate of inflation.

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Benefits of Inflation Swaps

✗ The two parties to the swap come to an agreement based on their

respective takes on what the inflation rate is likely to be for the
period of time in question.

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 Special Considerations
✗ The currency of the swap determines the price index that is
used to calculate the rate of inflation.

✗ A ZCIS, like any debt contract, is vulnerable to default by

either side, whether due to temporary liquidity challenges or
more serious structural issues such as insolvency. Both parties
may agree to put up collateral for the amount owed to lessen
this risk.

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 Special Considerations
✗ Real yield inflation swaps, price index inflation swap,
Treasury Inflation-Protected Securities (TIPS), municipal and
corporate inflation-linked securities, inflation linked
certificates of deposit, and inflation-linked savings bonds are
some of the other financial instruments that can be used to
hedge against inflation risk.

References:
https://www.investopedia.com/terms/z/zero-coupon-inflation-swap.asp

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Thanks
!
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