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The Impact of Collateralization on Swap Rates

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  • MICHAEL JOHANNES
  • SURESH SUNDARESAN

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.

Suggested Citation

  • Michael Johannes & Suresh Sundaresan, 2007. "The Impact of Collateralization on Swap Rates," Journal of Finance, American Finance Association, vol. 62(1), pages 383-410, February.
    • Handle: RePEc:bla:jfinan:v:62:y:2007:i:1:p:383-410
    DOI: 10.1111/j.1540-6261.2007.01210.x
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