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The Impact of Collateralization on Swap Rates

Authors

  • MICHAEL JOHANNES,

  • SURESH SUNDARESAN

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    • Johannes and Sundaresan are with the Columbia Business School. We thank seminar participants at University of California-Berkeley, Carnegie Mellon, Citigroup, Columbia, Lehman Brothers, Morgan Stanley, NYU, Norwegian School of Economics, Norwegian School of Management, Northwestern, and Stanford. We thank Kaushik Amin, Stephen Blythe, Keith Brown, Qiang Dai, Darrell Duffie, Frank Edwards, Massoud Heidari, Ed Morrison, Scott Richard, Tano Santos, Ken Singleton, and especially the anonymous referee and Pierre Collin-Dufresne for their comments. Kodjo Apedjinou and Andrew Dubinsky provided excellent research assistance. All errors are our own.


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.

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