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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. Copyright 2007 by The American Finance Association.

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
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