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

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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.

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  • Ana Fostel & John Geanakoplos, 2011. "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes," Cowles Foundation Discussion Papers 1809, Cowles Foundation for Research in Economics, Yale University.
    • Handle: RePEc:cwl:cwldpp:1809
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    More about this item

    Keywords

    Financial innovation; Endogenous leverage; Collateral equilibrium; CDS; Tranching and asset prices;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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