Controlling Information Premia by Repackaging Asset-Backed Securities

Securities created from a base of underlying receivables are sold to 'individual' and 'institutional' traders. While both classes of traders are uninformed about the payoff characteristics of receivables, institutions are more sophisticated than individuals because they are aware of the information-based transactions costs of all currently open markets. Based on their customers' needs, they carry out any given level of transactions by minimizing transaction costs across all open markets. Closed-form solutions for the optimal correlation between the receivables and the number of securities to be issued are provided as functions of (I) the objective of the security designer, which might be to maximize or minimize the profits earned off each kind of trader; (ii) the masses of each kind of trader in the market; and (iii) the elasticities of traders hedging demands with respect to transaction costs. All three parameters can be measured empirically by practitioners. It is found that while profits earned off individuals can be optimized by changing the correlation coefficient between sets of receivables backing different securities, profits earned off institutions are immune to changes in the correlation and can be controlled only by altering the number of securities created. This paper was presented at the Financial Institutions Center's May 1996 conference on "