Abstract
A growing body of theoretical and empirical literature addresses the timely issue of flight-to-quality and flight-to-liquidity episodes in financial markets. Recent returns on the various credit tranches of the ABX, a widely used derivative that provides exposure to an index of subprime mortgage-backed securities, are ideal for studying the interplay among fundamental news, flights-to-quality, and flights-to-liquidity. By interpreting principal component loadings and regressing the estimated components on financial and economic variables, this article offers evidence that, during the subprime crisis, ABX returns have been primarily determined by 1) a large first component that proxies for mostly fundamental information and 2) a still sizeable but smaller second component that is unrelated to fundamentals and proxies for flight-to-quality behavior.The author then interprets the two components in a portfolio context after adjusting for economic leverage. Finally, the author shows that subprime mortgage-backed securities are still in the midst of a sizeable flight-to-quality episode and that a portfolio that is perfectly negatively correlated with the second principal component should 1) exhibit abnormal profits when the flight-to-quality effect dissipates and 2) be ex-ante hedged against fundamental risk. <b>TOPICS:</b>MBS and residential mortgage loans, credit default swaps, statistical methods, financial crises and financial market history
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