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Andrew Ellis, Ph.D.

London School of Economics, United Kingdom

Authors: Andrew Ellis, Michele Piccione, and Shengxing Zhang

Abstract: We consider an environment in which investors disagree about the correlation between the assets underlying an asset backed security (ABS). Holders of the ABS can issue feasible, increasing contracts (promises to pay) collateralized by the ABS. In the essentially unique equilibrium, holders tranche the asset and profit by screening investors' misperception of payoff correlation across assets. Tranching facilitates betting on the correlation between assets, and acts to transfer surplus to holders of the asset. Investors who underestimate the aggregate risk, i.e., the correlation of payoffs across assets, hold senior tranches that they believe are safe, while Bankers or other insiders who believe the correlation is higher hold junior tranches. When investors' wealth constraint is not binding, the equilibrium tranching is invariant to the degree of misperception.

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