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ABSTRACT

Interest rate swap pricing theory traditionally views swaps as a portfolio of forward contracts with net swap payments discounted at LIBOR rates. In practice, the use of marking-to-market and collateralization questions this view as they introduce intermediate cash flows and alter credit characteristics. We provide a swap valuation theory under marking-to-market and costly collateral and examine the theory's empirical implications. We find evidence consistent with costly collateral using two different approaches; the first uses single-factor models and Eurodollar futures prices, and the second uses a formal term structure model and Treasury/swap data.