Collateral Expansion: Pricing Spillovers from Financial Innovation


Financial innovation is the use of new kinds of collateral or new kinds of promises backed by existing collateral. We study the effect of collateral-based financial innovation in a general equilibrium model with incomplete markets and provide precise predictions about cross-price spillovers. Whereas leverage has positive price spillovers on other markets, tranching and credit default swaps have negative price spillovers on other asset markets. Our results underscore a new mechanism (collateral-based financial innovation) that can explain cross-market spillovers without relying on traditional contagion (portfolio/fire-sale) channels.

Working Paper