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Security Baskets and Index-Linked Securities

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  • Gary Gorton
  • George Pennacchi

Abstract

Security baskets and index-lined securities are securities whose values are functions of the cash flows or values of other assets. Creation of these "composite" securities would seem to be redundant since investors can cost1ess1y replicate them. In this paper we study the existence and optimal design of composite securities. We first show that when some investors possess inside information, composite securities are not redundant. By holding composite securities, uninformed investors with unexpected needs to trade can reduce their expected losses to insiders. The existence of these securities will affect real investment decisions. We then show that when uniformed investors are heterogeneous with respect to nontradeable endowment risk, the size of such clienteles determines whether the portfolio for a liquidity trader consists of a clientele-specific composite or a single market composite combined with individual security holdings. In the latter case, markets for the composite security and its component securities coexist. No results depend on the existence of exogenous "noise" traders.

Suggested Citation

  • Gary Gorton & George Pennacchi, 1991. "Security Baskets and Index-Linked Securities," NBER Working Papers 3711, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:3711
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    References listed on IDEAS

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    5. Mark Rubinstein., 1989. "Market Basket Alternatives," Research Program in Finance Working Papers RPF-187, University of California at Berkeley.
    6. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
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