Security Baskets and Index-Linked Securities

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.