Equilibrium Securitization with Diverse Beliefs

Abstract

We study the effects of diverse beliefs on equilibrium securitization. We provide a simple characterization of the optimal securities. Pooling and tranching of assets emerges in equilibrium as a consequence of traders’ diverse beliefs about asset returns. Under risk neutrality, the issuer of securities tranches the asset pool, and traders sort among the tranches according to their beliefs. We show how the traders’ disagreement about the correlation of asset returns is a key factor in determining which assets are pooled.