M. Suresh Sundaresan
Pricing Collateralized Swaps
Coauthor(s): Michael Johannes.
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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.
Suresh Sundaresan, M. "Pricing Collateralized Swaps." Columbia Business School, March 2003.