The Impact of Margin Interest on the Valuation of Credit Default Swaps

Abstract

These days, both exchange-traded and most OTC derivatives transactions are collateralized: The upfront payment, if any, and regular mark-to-market variation margin are held in escrow, possibly earning interest, until the contract is exercised. In theoretical modeling, interest paid on the collateral is typically ignored, under the assumption that the mark-tomarket cash flows can go either way and, in any case, the interest amounts are small. Kan and Pedersen demonstrate that this intuition is not necessarily true. For credit default swaps (CDS), the impact of margin interest can be significant; in fact, the margin interest rate should be used for discounting in calculating the fair value of CDS.