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American Economic Journal: Macroeconomics: Vol. 4 No. 1 (January 2012)

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Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes

Article Citation

Fostel, Ana, and John Geanakoplos. 2012. "Tranching, CDS, and Asset Prices: How Financial Innovation Can Cause Bubbles and Crashes." American Economic Journal: Macroeconomics, 4(1): 190-225.

DOI: 10.1257/mac.4.1.190

Abstract

We show how the timing of financial innovation might have contributed to the mortgage bubble and then to the crash of 2007-2009. We show why tranching and leverage first raised asset prices and why CDS lowered them afterward. 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. (JEL E32, E44, G01, G12, G13, G21).

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Authors

Fostel, Ana (George Washington U)
Geanakoplos, John (Yale U and Santa Fe Institute)

JEL Classifications

E32: Business Fluctuations; Cycles
E44: Financial Markets and the Macroeconomy
G01: Financial Crises
G12: Asset Pricing; Trading volume; Bond Interest Rates
G13: Contingent Pricing; Futures Pricing; option pricing
G21: Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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American Economic Journal: Macroeconomics


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