COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 1809 Tranching, CDS and Asset Prices: Ana Fostel and John Geanakoplos July 23, 2011 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. |
