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Security Baskets and Index-Linked Securities

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  • George Pennacchi
  • Gary Gorton

Abstract

Security baskets and index-linked securities are securities whose values are functions of the cash flows or values of other assets. Intermediaries create security baskets by pooling or bundling more primitive assets such as mortgages, credit card receivables and other loans, or equities as in the case of closed-end mutual funds. Index-linked securities, such as index participations and stock index futures, are created by stock and futures exchanges. Creation of these "composite" securities would appear to be redundant if investors could individually purchase the securities that compose the security basket or index, thus creating their own diversified portfolios. However, we show that when some investors possess inside information, composite securities are not redundant. They provide superior "liquidity" for uninformed investors. By holding these securities, uninformed investors with unexpected needs to trade can reduce their expected losses to investors with inside information. Moreover, the existence of these securities affects real investment decisions and equilibrium rates of return. We provide an application of our model to the problem of international portfolio choice and mutual fund design.

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Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 29-89.

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Handle: RePEc:fth:pennfi:29-89

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  1. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  3. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  4. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
  5. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  6. Mark Rubinstein., 1989. "Market Basket Alternatives," Research Program in Finance Working Papers RPF-187, University of California at Berkeley.
  7. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
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