The Mechanism Of ABS Tranching Structure

Asset Backed Securities is an innovative structured finance instrument that has brought profound changes to the global financial markets. With the domestic financial system maturing, ABS began to emerge in the domestic market. This paper attempts to prove the rationality and effectiveness of the mechanism of Asset Backed Securities from the theoretical perspective so that we can get a deep understanding of this instrument and lay the foundation for better practice. This paper focuses on three key aspects of ABS, namely securitization, hierarchical structure and retention ratio. By studying these, we analyze the risk diversification, risk appetite adaptation and signaling role arising from ABS’ intrinsic mechanism.First, by inferring to Arrow-Lind theorem, this paper clarifies the risk diversification role of ABS. With the increase in the number of investors, the sum of the risk premium required by investors gradually reduces, so is the issuer’s financing cost. When approaching an infinite number, risk-averse investor groups present a risk-neutral characteristic.Second, this paper analyzes the hierarchy structure’s role on reallocating the risk of basic assets. After the theoretical analysis, tranching help reduce the overall risk, but will increase the unit risk. Therefore, under the assumption that investors are CARA, tranching will reduce the risk premium; while assuming investors are CRRA, tranching will increase the risk premium. Also, when there are many types of risk appetites, the investors with high degree of risk aversion will choose securities with high priority and investors with low risk aversion would choose securities with lower priority, so that the total risk premium will be reduced.Finally, this article further expands the D&D model to analyze the problem of retention ratio in the case of multi-layered securities. Under the assumption that there’re only two possible asset qualities, lower priority securities go with higher optimal retention ratio; while there’re many asset qualities, the constraint induced by signaling plays a substantial role, and therefore the conclusion is much simpler, which is that only junior tranche need to maintain a certain retention ratio while senior tranches are totally sold.