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.

The presence of a well designed bankruptcy code is an important part of the financial architecture in developed economies. By allowing the creditors to seize the assets of the borrowers who fail to make contractual payments, the code generates beneficial ex ante effects on debt capacity and firm value. By giving the borrowers options to renegotiate their debt obligations and seek bankruptcy protection, the code increases the likelihood that borrowers may avoid inefficient ex post liquidation. As Hart (1999) notes, the code should balance ex ante firm value maximization with ex post efficiency. The bankruptcy codes in different countries weight this tradeoff differently and hence vary in terms of the distribution of rights and powers between borrowers and lenders. In this paper, we provide an inter-temporal framework to examine how the creditors’ liquidation rights and the distribution of ex post bargaining powers influence the firm’s investment and financing decisions, and affect ex ante firm value. We show that stronger equityholders ’ bargaining power lowers debt capacity, reduces firm value, and discourages growth option exercising. Our calibration suggests that the quantitative effects of ex post strategic renegotiation on ex ante firm value may be large.

Explicit presence of reorganization in addition to liquidation leads to conflicts of interest between borrowers and lenders. In the first–best outcome, reorganization adds value to both parties via higher debt capacity, lower credit spreads, and improved overall firm value. If control of the ex ante reorganization timing and the ex post decision to liquidate is given to borrowers, most of the benefits are appropriated by borrowers ex post. Lenders can restore the first–best outcome by seizing this control or by the ex post transfer of control rights. Reorganization is more likely and liquidation is less likely relative to the benchmark case with liquidation only.