What Is a Zero Coupon Swap?

Swaps are a type of derivative, or asset-backed security, where counter-parties arrange payments based on fixed and floating interest rates paid at set intervals across the life of the contract. A zero coupon swap, based upon a zero coupon bond, changes the interest so that the floating rate is paid on interval, while the fixed rate is paid in one sum at contract's end. Alternative swap payments are possible, including the reverse and exchangeable zero coupon swaps. Currency backed coupons swaps have a different payment arrangement that's based on inflation.

Standard swap agreements involve two forms of interest and a nominal principal. The first party agrees to interval payments to the second party using a fixed interest rate that's based on the principal and guaranteed not to change over the life of the contract. Floating interest payments, prone to market fluctuation within a predefined spread, are made on the same interval dates by the second party.

In the case of a zero coupon swap, floating rate payments are still performed on an interval schedule and are based on an underlying zero coupon bond. As a result, fixed-rate payments change to a one-time payment at the end of the contract allowing the zero coupon bond to be bought at a deep discount and to pay no interest until it reaches maturity, potentially causing the bond's value to fluctuate broadly over the course of its life. A traditional zero coupon swap places the risk on the party paying the floating payments, and the structure and risk of such makes them similar to a loan agreement. Swaps happen on the over-the-counter market, where parties are more vulnerable to nonpayment.

Alternative payment methods can be arranged to minimize or transfer risk. One that places the fixed rate payment on a interval schedule, making the agreement more like a standard swap agreement, is referred to as an exchangeable zero coupon swap. Another type is the reverse zero coupon swap, which reduces the risk for the floating interest payee since the floating interval payment schedule is maintained, but the fixed rate payment is made upfront. Zero inflation coupon swaps are a similarly-named investment agreement with a quite different method of operation, as the underlying asset is currency and the floating rate is based on inflation. Fixed and floating rate payments are both made once, at the end, based on the known inflation level.