Collateral-Motivated Financial Innovation

50 Pages Posted: 8 Mar 2012 Last revised: 16 Aug 2014

See all articles by Ji Shen

Ji Shen

London School of Economics & Political Science (LSE)

Hongjun Yan

DePaul University

Jinfan Zhang

International Monetary Fund

Date Written: January 24, 2014


Collateral frictions have a profound effect on our economic landscape, ranging from the design of financial securities, laws, institutions, to various rules and regulations. We analyze a model with disagreement, where securities and collateral requirements are endogenous. It shows that the security that isolates the variable with disagreement is “optimal” in the sense that alternative securities cannot generate any trading. In an economy with N states, investors may introduce more than N securities, and markets are still incomplete. The model has several novel predictions on the behavior of basis — the spread between the prices of an asset and its replicating portfolio.

Keywords: Financial Innovation, Collateral, Financial Intermediation, Leverage

JEL Classification: G11, G23

Suggested Citation

Shen, Ji and Yan, Hongjun and Zhang, Jinfan, Collateral-Motivated Financial Innovation (January 24, 2014). Available at SSRN: or

Ji Shen

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Hongjun Yan (Contact Author)

DePaul University ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States


Jinfan Zhang

International Monetary Fund ( email )

700 19th St NW
Washington, DC 20431
United States

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