Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes

48 Pages Posted: 16 Jul 2011 Last revised: 26 Jul 2011

Ana Fostel

University of Virginia

John Geanakoplos

Yale University - Cowles Foundation

Multiple version iconThere are 2 versions of this paper

Date Written: July 23, 2011

Abstract

We show how the timing of financial innovation might have contributed to the mortgage boom and then to the bust of 2007-2009. We study the effect of leverage, tranching, securitization and CDS on asset prices in a general equilibrium model with collateral. We show why tranching and leverage tend to raise asset prices and why CDS tend to lower them. This may seem puzzling, since it implies that creating a derivative tranche in the securitization whose payoffs are identical to the CDS will raise the underlying asset price while the CDS outside the securitization lowers it. The resolution of the puzzle is that the CDS lowers the value of the underlying asset since it is equivalent to tranching cash.

Keywords: Financial innovation, Endogenous leverage, Collateral equilibrium, CDS, Tranching and Asset prices

JEL Classification: D52, D53, E44, G01, G10, G12

Suggested Citation

Fostel, Ana and Geanakoplos, John, Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (July 23, 2011). Cowles Foundation Discussion Paper No. 1809. Available at SSRN: https://ssrn.com/abstract=1886466 or http://dx.doi.org/10.2139/ssrn.1886466

Ana Fostel

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

John D Geanakoplos (Contact Author)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States
203-432-3397 (Phone)
203-432-6167 (Fax)

HOME PAGE: http://cowles.econ.yale.edu/P/au/d_gean.htm

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