Securitization and Volatility
The originator passing on the risks (or sharing risks) in financial transactions is the general end result of asset-based securitization. It can be shown that volatility (measured as the variance in the recovery of receivables) increases in at least four contexts. (a) The originator does not share the risk and consequently expands into high-risk activities to increase his business. This depends on the efficiency of the special purpose vehicle (SPV) in collecting receivables and how consideration is defined at the time of securitization. However, there will be limits on volatility beyond which the originator does not gain. (b) The size of any one securitized pool may be small compared to the total business of the SPV. Portfolio choice based on the risk-adjusted rate of return becomes important in such a context. In an expanding market, the originator and/or the SPV may find the risk-adjusted rate of return on securitization even higher with increasingly risky transactions. He will then expand into activities that increase the volatility of transactions. (c) The investor, who buys the pass-through certificates issued by the SPV, may find securitized transactions more attractive relative to conventional financial instruments either due to lower transaction costs, shorter time horizon over which they are recovered, or higher risk-adjusted rate of return. Even this has the effect of increasing the volatility of financial transactions. (d) The parties tend to utilize credit rating agencies to indicate the risks involved and reduce their adverse impact. However, their commercial interests may result in ratings that augment and spread risks instead of containing them within desirable limits.
KeywordsNash Equilibrium Credit Rating Risky Asset Financial Instrument Financial Transaction
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