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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. A positive basis emerges when derivative contracts backed by an asset can be used as collateral to issue additional financial promises. 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, 2021. "Collateral Constraints, Tranching, and Price Bases," Department of Economics Working Papers 2021-07, Department of Economics, Williams College.
    • Handle: RePEc:wil:wileco:2021-07
    DOI: 10.36934/wecon:2021-07
    Note: This is an update of working paper 2020-03
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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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