IDEAS home Printed from https://ideas.repec.org/p/wil/wileco/2019-18.html
   My bibliography  Save this paper

Debt Collateralization, Structured Finance, and the CDS Basis

Author

Listed:
  • Feixue Gong

    (Massachusetts Institute of Technology)

  • Gregory Phelan

    (Williams College)

Abstract

Tranching an asset increases its basis; tranching a CDS, as occurs with the CDX index, increases the CDS basis on the underlying asset. We study how the ability to use financial contracts as collateral affects the CDS basis using a general equilibrium model with collateralized financial promises and multiple states of uncertainty. A positive basis emerges when risky assets and their derivative debt contracts can be used as collateral for financial promises. We provide an empirical test of our theory using inclusion in the CDX and find that inclusion in the CDX increases the CDS basis.

Suggested Citation

  • Feixue Gong & Gregory Phelan, 2019. "Debt Collateralization, Structured Finance, and the CDS Basis," Department of Economics Working Papers 2019-18, Department of Economics, Williams College.
    • Handle: RePEc:wil:wileco:2019-18
    Note: This is an update of WP 2016-06
    as

    Download full text from publisher

    File URL: https://web.williams.edu/Economics/wp/GongPhelanDebtCollateralizationStructuredFinanceCDSBasis.pdf
    File Function: Full text
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Bottazzi, Jean-Marc & Luque, Jaime & Páscoa, Mário R., 2012. "Securities market theory: Possession, repo and rehypothecation," Journal of Economic Theory, Elsevier, vol. 147(2), pages 477-500.
    2. repec:bla:jfinan:v:59:y:2004:i:4:p:1901-1930 is not listed on IDEAS
    3. Piero Gottardi & Felix Kubler, 2015. "Dynamic Competitive Economies with Complete Markets and Collateral Constraints," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 82(3), pages 1119-1153.
    4. Gregory Phelan, 2017. "Collateralized borrowing and increasing risk," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 63(2), pages 471-502, February.
    5. John Geanakoplos & William Zame, 2014. "Collateral equilibrium, I: a basic framework," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 56(3), pages 443-492, August.
    6. Feixue Gong & Gregory Phelan, 2020. "Debt collateralization, capital structure, and maximal leverage," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 70(2), pages 579-605, September.
    7. Jeffrey Wurgler & Ekaterina Zhuravskaya, 2002. "Does Arbitrage Flatten Demand Curves for Stocks?," The Journal of Business, University of Chicago Press, vol. 75(4), pages 583-608, October.
    8. Banerjee, Snehal & Graveline, Jeremy J., 2014. "Trading in derivatives when the underlying is scarce," Journal of Financial Economics, Elsevier, vol. 111(3), pages 589-608.
    9. Jean-Marc Bottazzi & Jaime Luque & Mário R. Páscoa, 2012. "Securities market theory: Possession, repo and rehypothecation," Post-Print hal-01648216, HAL.
    10. Andrei Shleifer & Robert Vishny, 2011. "Fire Sales in Finance and Macroeconomics," Journal of Economic Perspectives, American Economic Association, vol. 25(1), pages 29-48, Winter.
    11. Jan De Wit, 2006. "Exploring the CDS-Bond Basis," Working Paper Research 104, National Bank of Belgium.
    12. Nicolae Gârleanu & Lasse Heje Pedersen, 2011. "Margin-based Asset Pricing and Deviations from the Law of One Price," The Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 1980-2022.
    13. Oehmke, Martin & Zawadowski, Adam, 2015. "Synthetic or real? The equilibrium effects of credit default swaps on bond markets," LSE Research Online Documents on Economics 84511, London School of Economics and Political Science, LSE Library.
    14. Jean-Marc Bottazzi & Jaime Luque & Mário R. Páscoa, 2012. "Securities market theory: Possession, repo and rehypothecation," PSE-Ecole d'économie de Paris (Postprint) hal-01648216, HAL.
    15. Francis A. Longstaff & Arvind Rajan, 2008. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," Journal of Finance, American Finance Association, vol. 63(2), pages 529-563, April.
    16. Harris, Lawrence E & Gurel, Eitan, 1986. "Price and Volume Effects Associated with Changes in the S&P 500 List: New Evidence for the Existence of Price Pressures," Journal of Finance, American Finance Association, vol. 41(4), pages 815-829, September.
    17. John Geanakoplos & Ana Fostel, 2008. "Leverage Cycles and the Anxious Economy," American Economic Review, American Economic Association, vol. 98(4), pages 1211-1244, September.
    18. Nashikkar, Amrut & Subrahmanyam, Marti G. & Mahanti, Sriketan, 2011. "Liquidity and Arbitrage in the Market for Credit Risk," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(3), pages 627-656, June.
    19. Jaewon Choi & Or Shachar, 2013. "Did liquidity providers become liquidity seekers?," Staff Reports 650, Federal Reserve Bank of New York.
    20. Jean-Marc Bottazzi & Jaime Luque & Mário R. Páscoa, 2012. "Securities market theory: Possession, repo and rehypothecation," Université Paris1 Panthéon-Sorbonne (Post-Print and Working Papers) hal-01648216, HAL.
    21. Ji Shen & Hongjun Yan & Jinfan Zhang, 2014. "Collateral-Motivated Financial Innovation," The Review of Financial Studies, Society for Financial Studies, vol. 27(10), pages 2961-2997.
    22. Joshua D. Rauh & Amir Sufi, 2010. "Capital Structure and Debt Structure," The Review of Financial Studies, Society for Financial Studies, vol. 23(12), pages 4242-4280, December.
    23. Phelan, Gregory & Toda, Alexis Akira, 2019. "Securitized markets, international capital flows, and global welfare," Journal of Financial Economics, Elsevier, vol. 131(3), pages 571-592.
    24. Martin Oehmke & Adam Zawadowski, 2015. "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets," The Review of Financial Studies, Society for Financial Studies, vol. 28(12), pages 3303-3337.
    25. Jean-Marc Bottazzi & Jaime Luque & Mário Páscoa, 2012. "Securities market theory: Possession, repo and rehypothecation," Post-Print hal-00665629, HAL.
    26. Alp Simsek, 2013. "Belief Disagreements and Collateral Constraints," Econometrica, Econometric Society, vol. 81(1), pages 1-53, January.
    27. Roberto Blanco & Simon Brennan & Ian W. Marsh, 2005. "An Empirical Analysis of the Dynamic Relation between Investment‐Grade Bonds and Credit Default Swaps," Journal of Finance, American Finance Association, vol. 60(5), pages 2255-2281, October.
    28. Diane K. Denis & John J. McConnell & Alexei V. Ovtchinnikov & Yun Yu, 2003. "S&P 500 Index Additions and Earnings Expectations," Journal of Finance, American Finance Association, vol. 58(5), pages 1821-1840, October.
    29. Jean-Marc Bottazzi & Jaime Luque & Mário Páscoa, 2012. "Securities market theory: Possession, repo and rehypothecation," PSE-Ecole d'économie de Paris (Postprint) hal-00665629, HAL.
    30. Shleifer, Andrei, 1986. "Do Demand Curves for Stocks Slope Down?," Journal of Finance, American Finance Association, vol. 41(3), pages 579-590, July.
    31. Matt Darst & Ehraz Refayet, 2016. "Credit Default Swaps in General Equilibrium: Spillovers, Credit Spreads, and Endogenous Default," Finance and Economics Discussion Series 2016-042, Board of Governors of the Federal Reserve System (U.S.).
    32. Adonis Antoniades & Nikola Tarashev, 2014. "Securitisations: tranching concentrates uncertainty," BIS Quarterly Review, Bank for International Settlements, December.
    33. Benjamin Junge & Anders B. Trolle, 2013. "Liquidity Risk in Credit Default Swap Markets," Swiss Finance Institute Research Paper Series 13-65, Swiss Finance Institute, revised Aug 2015.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Feixue Gong & Gregory Phelan, 2020. "Debt collateralization, capital structure, and maximal leverage," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 70(2), pages 579-605, September.
    2. Ana Fostel & John Geanakoplos & Gregory Phelan, 2015. "Global Collateral: How Financial Innovation Drives Capital Flows and Increases Financial Instability," Department of Economics Working Papers 2015-12, Department of Economics, Williams College, revised Feb 2017.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. 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.
    2. Gong Feixue & Gregory Phelan, 2017. "Debt Collateralization, Structured Finance, and the CDS Basis," Department of Economics Working Papers 2017-06, Department of Economics, Williams College.
    3. Johannes Brumm & Michael Grill & Felix Kubler & Karl Schmedders, 2023. "Re-use of collateral: Leverage, volatility, and welfare," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 47, pages 19-46, January.
    4. Maurin, Vincent, 2022. "Asset scarcity and collateral rehypothecation," Journal of Financial Intermediation, Elsevier, vol. 52(C).
    5. Jun Kyung Auh & Mattia Landoni, 2022. "Loan Terms and Collateral: Evidence from the Bilateral Repo Market," Journal of Finance, American Finance Association, vol. 77(6), pages 2997-3036, December.
    6. Piero Gottardi & Vincent Maurin & Cyril Monnet, 2019. "A theory of repurchase agreements, collateral re-use, and repo intermediation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 30-56, July.
    7. Feixue Gong & Gregory Phelan, 2020. "Debt collateralization, capital structure, and maximal leverage," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 70(2), pages 579-605, September.
    8. Piero Gottardi & Vincent Maurin & Cyril Monnet, 2019. "A theory of repurchase agreements, collateral re-use, and repo intermediation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 30-56, July.
    9. Piero Gottardi & Vincent Maurin & Cyril Monnet, 2023. "Fragility of Secured Credit Chains," Diskussionsschriften dp2304, Universitaet Bern, Departement Volkswirtschaft.
    10. Minh-Quan Nguyen & Nhat-Tan Le & Khuong Nguyen-An & Duc-Thi Luu, 2024. "An Integral Equation Approach for the Valuation of Finite-maturity margin-call Stock Loans," Papers 2407.14728, arXiv.org.
    11. Gottardi, Piero & Maurin, Vincent & Monnet, Cyril, 2021. "Financial Fragility with Collateral Circulation," CEPR Discussion Papers 15757, C.E.P.R. Discussion Papers.
    12. Park, Hyejin & Kahn, Charles M., 2019. "Collateral, rehypothecation, and efficiency," Journal of Financial Intermediation, Elsevier, vol. 39(C), pages 34-46.
    13. Yu Awaya & Hiroki Fukai & Makoto Watanabe, 2021. "A Model Of Collateral: Endogenizing The Borrowing Constraint," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 62(3), pages 1131-1151, August.
    14. Augustin, Patrick & Subrahmanyam, Marti G. & Tang, Dragon Yongjun & Wang, Sarah Qian, 2014. "Credit Default Swaps: A Survey," Foundations and Trends(R) in Finance, now publishers, vol. 9(1-2), pages 1-196, December.
    15. Oehmke, Martin & Zawadowski, Adam, 2015. "Synthetic or real? The equilibrium effects of credit default swaps on bond markets," LSE Research Online Documents on Economics 84511, London School of Economics and Political Science, LSE Library.
    16. Eisenschmidt, Jens & Ma, Yiming & Zhang, Anthony Lee, 2024. "Monetary policy transmission in segmented markets," Journal of Financial Economics, Elsevier, vol. 151(C).
    17. repec:spo:wpmain:info:hdl:2441/2b7q60gmqo82aqr0p34bieidke is not listed on IDEAS
    18. Luu, Duc Thi & Napoletano, Mauro & Barucca, Paolo & Battiston, Stefano, 2021. "Collateral Unchained: Rehypothecation networks, concentration and systemic effects," Journal of Financial Stability, Elsevier, vol. 52(C).
    19. Tomás Carrera de Souza & Tom Hudepohl, 2022. "The Eurosystem’s bond market share at an all-time high: what does it mean for repo markets?," Working Papers 745, DNB.
    20. Sebastian Infante, 2015. "Liquidity Windfalls: The Consequences of Repo Rehypothecation," Finance and Economics Discussion Series 2015-22, Board of Governors of the Federal Reserve System (U.S.).
    21. Shengxing Zhang, 2014. "Collateral Risk, Repo Rollover and Shadow Banking," 2014 Meeting Papers 562, Society for Economic Dynamics.

    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

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wil:wileco:2019-18. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Stephen Sheppard (email available below). General contact details of provider: https://edirc.repec.org/data/edwilus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.