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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?

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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.

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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.

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If you introduce a repo dealer into the equation (so as to finance the initial 100), then the cash flow structure looks as follows:

enter image description here

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.

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