The Impact of Collateralization on Swap Rates
by Michael Johannes of Columbia University, and
May 29, 2003
Abstract: Interest rate swap pricing theory traditionally views swaps as portfolios of forward contracts with net swap payments discounted using the LIBOR curve. Current market practices of marking-to-market and collateralization question this view. Collateralization and marking-to-market affects discounting of swap payments (through altered default characteristics) and introduces intermediate cash-flows. This paper provides a theory of swap valuation under collateralization and we find evidence supporting the presence of costly collateral. Using Eurodollar futures rates, we find evidence that swaps are priced above the traditional portfolio of forwards value and below a portfolio of futures value. Moreover, the effect of collateral is time varying. We estimate a term structure model to characterize the cost of collateral and quantify its effect on swap rates.
Published in: Journal of Finance, Vol. 62. No, 1, (February 2007), pp. 383-410.
Previously titled: "Pricing Collateralized Swaps"