Collateral-Motivated Financial Innovation
50 Pages Posted: 8 Mar 2012 Last revised: 16 Aug 2014
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: Suggested Citation