Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes
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.
Fostel, Ana and Geanakoplos, John, "Tranching, CDS and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes" (2011). Cowles Foundation Discussion Papers. 2154.