Intermediation and Value Creation in an Incomplete Market: Implications for Securitization

Posted: 5 Nov 2008

See all articles by Vishal Gaur

Vishal Gaur

Cornell University - Samuel Curtis Johnson Graduate School of Management

Sridhar Seshadri

University of Illinois at Urbana Champaign; Indian School of Business

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: October 2005

Abstract

This paper studies the impact of financial innovations on real investment decisions. We model an incomplete market economy comprised of firms, investors and an intermediary. The firms face unique investment opportunities that are not spanned by the traded securities in the financial market, and thus, cannot be priced uniquely using the no-arbitrage principle. The specific innovation we consider is securitization; the intermediary buys claims from the firms that are fully backed by cash flows from the new projects, pools these claims together, and then issues tranches of secondary securities to the investors. We first derive necessary and sufficient conditions under which pooling provides value enhancement and the prices paid to the firms are acceptable to them compared to the no-investment option or the option of forming alternative pools. We find that there is a unique pool that is sustainable, and may or may not consist of all projects in the intermediary's consideration set. We then determine the optimal design of tranches, fully backed by the asset pool, to be sold to different investor classes. We determine the general structure of the tranches. The new securities created by the intermediary could have up to three components, one that is a marketable claim, one that represents the arbitrage opportunities available in the market due to special ability to design and sell securities to a subset of investors, and a third component that is the rest of the asset pool which is sold at a price which does not exceed arbitrage based bounds to investors. The presence of these three components in the tranching solution has direct bearing upon the size of the asset pool, and therefore value creation due to financing additional projects.

Suggested Citation

Gaur, Vishal and Seshadri, Sridhar and Subrahmanyam, Marti G., Intermediation and Value Creation in an Incomplete Market: Implications for Securitization (October 2005). NYU Working Paper No. S-DRP-05-05. Available at SSRN: https://ssrn.com/abstract=1295846

Vishal Gaur

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States

HOME PAGE: http://www.johnson.cornell.edu/faculty/profiles/Gaur/

Sridhar Seshadri

University of Illinois at Urbana Champaign ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

Indian School of Business ( email )

Hyderabad, Gachibowli 500 019
India

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

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