Collateral Constraints, Tranching, and Price Bases

Abstract: Tranching an asset increases its basis; tranching a CDS, as occurs with the CDX index, increases the basis on the underlying asset. We consider a general equilibrium model with collateralized financial promises and multiple states of uncertainty to study how allowing an asset to back multiple financial contracts (i.e., tranching) affects price bases. A positive basis emerges when risky assets and their derivative contracts can be used as collateral for financial promises. We provide an empirical test of our theory using inclusion in the CDX and find that inclusion in the CDX increases the CDS basis.

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