Collateral-Motivated Financial Innovation

Oxford-Man Institute Series

This paper argues that many financial innovations are partly motivated by alleviating collateral constraints. We analyze a model with disagreement, where derivatives and collateral requirements are endogenous, and find that due to a collateral friction in cross-netting, the derivative that isolates the variable with disagreement is “optimal” in the sense that alternative derivatives cannot generate any trading. Financial intermediation arises as a way to mitigate this collateral friction, leading to asset-backed securities and tranching. We demonstrate that in an economy with N states, investors may prefer to introduce more than N securities, and yet still don’t complete markets.


Honjun Yan

Tuesday, November 26, 2013 - 12:30
to 13:30