Zero Coupon Swap

A zero coupon swap is a swap in which the fixed rate cash flows on the zero coupon leg are not paid periodically. Rather they are compounded and paid only once, on the swap’s expiry date. The payments on the other leg (which can be based on a floating rate or a fixed rateFor a zero coupon swap on BRL, the second leg is always based on a floating rate.1) follow typical swap payment schedules. However, if this other leg is based on a floating rate, you can also choose that the interest should be compoundedCompounded interest means that any interest earned over a defined period is not paid at the end of that period. Instead the generated interest is added to the principal amount, and therefore interest is earned on the already generated interest until the next payment date. Although this feature is actually technically known as compounding the interest (whereby any previously generated interest will then also generate interest), many people think of it as simply increasing the notional.2.

In a zero coupon swap, generally the payment frequency and the fixing frequency of the second leg need to be the same. However, if this leg is based on a floating rate and you enable the Compounding feature for it, then you can then set the fixing (or compounding) frequency to be greater than the leg’s payment frequency. You can then also choose to have only one payment for this leg at maturity. In this case, the floating leg is referred to as the “zero-coupon” floating leg, since there are no coupon payments until the maturity date.

Advantages of a Zero Coupon Swap

Zero coupon swaps are used by:

Corporates to hedge a loan or issue whereby the interest is capitalized and paid at maturity.

Banks as a result of hedging (either in bond issuance or corporate hedging) for customers.

Investors because they are assured of the rate of return (this is the zero coupon rate). This is not true of a vanilla swap which has a yield or YTM (yield to maturity) because YTM is calculated assuming all coupons are reinvested at the YTM rate. And there is no guarantee that this will be the case.

Pricing a Zero Coupon Swap in SDX Interest Rates

When pricing a zero coupon swap in SDX Interest Rates, as soon as you enter a swap term the system enters the Zero Rate for the zero coupon leg as well as the Ending Notional ; the Starting Notional is automatically set by the system.

It is important to note that the definition and calculation of the zero rate, the starting notional and the ending notional are interlinked.

That is, if you then manually edit any one of these three values the system asks which of the other two values you want to recalculate (and therefore which value to keep constant).

So, for example, if you change the zero rate value it asks you whether you want to change the starting notional or the ending notional.

Note that:

Currently changes to the zero coupon leg’s zero rate, starting notional and ending notional values can only be made in the main pricing page, and not in the Cash Flow Dates window (where these fields are now read-only).

If you edit the zero coupon leg's start date or end date (whether manually or by editing this date for the funding leg) the system automatically updates the zero rate and the ending notional, while keeping the starting notional constant.

Overwriting the zero rate will result in the instrument having an NPV.

If you want to activate the compounding feature, you must then also choose the type of compounding that you want to implement. For more information see Compounding .