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Interview prep / Finance/Derivatives

Discounting a strong issuer's par bond on swaps

Question

A highly rated (e.g. AAA) issuer has a bond trading at par. If you revalue it by discounting its cash flows with the swap (LIBOR) curve, will you get a price at, above or below par?

Short answer

Below par. The swap curve reflects the credit of AA-rated banks, so it sits above the borrowing rates of a top-rated issuer. The bond's coupon is set at the issuer's lower par yield, so discounting it at the higher swap rates produces a value under par.

Adapted from Crack, Heard on the Street, Q2.48, p.31; question and answer rewritten by SelfMadeQuant.com.

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