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Collateral constraints, tranching, and price bases

Author

Listed:
  • Feixue Gong

    (Massachusetts Institute of Technology)

  • Gregory Phelan

    (Williams College)

Abstract

We consider a multi-state, general-equilibrium model with collateralized financial promises to study how allowing an asset to back multiple financial contracts (i.e., tranching) affects price bases. A basis emerges when one asset can be tranched to issue more derivative securities than can be backed by another asset. Variations in the ability to tranche an asset or to pyramid derivative debt lead to variations in price bases. Tranching a CDS, as occurs with the CDX index, increases the basis on the underlying asset. Our theory correctly predicts that inclusion in the CDX index increases the underlying CDS basis.

Suggested Citation

  • Feixue Gong & Gregory Phelan, 2023. "Collateral constraints, tranching, and price bases," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 75(2), pages 317-340, February.
    • Handle: RePEc:spr:joecth:v:75:y:2023:i:2:d:10.1007_s00199-022-01414-8
    DOI: 10.1007/s00199-022-01414-8
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    Cited by:

    1. Broer, Tobias & Kero, Afroditi, 2021. "Collateralization and asset price bubbles when investors disagree about risk," Journal of Banking & Finance, Elsevier, vol. 128(C).

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    More about this item

    Keywords

    Collateral; Securitized markets; Cash-synthetic basis; Credit default swaps; Asset prices; Credit spreads;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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