The Zero-coupon-for-Floating swap is a special type of interest rate swap. The fixed rate payer makes a single payment at the maturity date of the swap agreement, while the floating rate payer makes periodic payments throughout the swap period. For example, consider a financial institution that primarily attracts short term deposits and currently has large holdings of zero-coupon bonds that it purchased several years ago. At the time it purchased the bonds, it expected interest rates to decline. Now it has become concerned that interest rates will rise over time, which will not only increase its cost of funds but also reduce the market value of the bonds. This financial institution can request a swap period that matches the maturity of its bond holdings. If interest rates rise over the period of concern, the institution will be benefit from the swap arrangement, thereby offsetting any adverse effects on the institution cost of funds. The other party in this type of transaction might be a firm that expects interest rates to decline such a firm would be willing to provide floating rate payment based on this exception because the payments will decline over time, while the single payment to be received at the end of the swap period is fixed.
Definition