Can a market practitioner explain how par par asset swaps work? I understand the swap fixed leg has the same details as the bond i.e. the fixed rate is equal to the bond coupon rate. The way I look at it: the notional of the swap is the par value of the bond, otherwise fixed payments wouldn't match and the investor wants exposure to 100pct of the principal, but I don't understand why the Pv of the swap should be equal to 100-dirty price. There is something that doesn’t click in the way I look at it. Maybe a practical example would help... the investor buys the bond from the issuer at price 99 then wants to enter into par par swap, what's the rationale behind the swap pricing?
The investor wants to spend 100 on an investment and then receive a floating coupon equal to Libor + some spread. So, investor purchases a bond with price 99 and then does a swap where they pay an extra 1 upfront (thus, total payment =100) , then pays the bond coupon and receives Libor + some spread. Those are the mechanics.
Conceptually, a par/par asset swap may work as follows (details can always be customized):
- At trade inception, you buy a bond priced at $P + AI$. You pay 100 out of pocket (or via a repo). The residual amount, $P + AI - 100$, is obtained with a swap dealer as an asset swap.
- After the trade has been initiated, the coupon payments received from the bond are then sent to the swap dealer as the fixed payments on the swap. Meanwhile, you receive a floating payment equal to LIBOR plus a fixed spread on a notional amount of 100. This spread is the pre-determined par/par asset swap spread.
- Finally, on the maturity date, you receive the principal payment from the bond.
A simple schematic of the cash flows is shown below.
If you introduce a repo dealer into the equation (so as to finance the initial 100), then the cash flow structure looks as follows:
Note that the initial PV of the asset swap can be anything you want. If it's not $P + AI - 100$, the asset swap spread $s$ will simply be adjusted accordingly.