Collateral Constraints, Tranching, and Price Bases

Description
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. A positive basis emerges when derivative contracts backed by an asset can be used as collateral to issue additional financial promises. 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.

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