Collateral constraints, tranching, and price bases

Abstract

Abstract We consider a multi-state, general-equilibrium model with collateralized financial promises to study how allowing an asset to back multiple financial contracts (i.e., tranching) affects price bases. A basis emerges when one asset can be tranched to issue more derivative securities than can be backed by another asset. Variations in the ability to tranche an asset or to pyramid derivative debt lead to variations in price bases. Tranching a CDS, as occurs with the CDX index, increases the basis on the underlying asset. Our theory correctly predicts that inclusion in the CDX index increases the underlying CDS basis.