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

Ana Fostel and John Geanakoplos ()
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John Geanakoplos: Cowles Foundation, Yale University, https://economics.yale.edu/people/faculty/john-geanakoplos

No 1809, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

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.

Keywords: Financial innovation; Endogenous leverage; Collateral equilibrium; CDS; Tranching and asset prices (search for similar items in EconPapers)
JEL-codes: D52 D53 E44 G01 G10 G12 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2011-07
New Economics Papers: this item is included in nep-ban and nep-cba
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Related works:
Journal Article: Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2012)
Working Paper: Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2011)
Working Paper: Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2011)
Working Paper: Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes (2011)
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