International Financial Contagion During the Subprime Crisis: Evidence from UK Financial Markets

Abstract

In this paper, we investigate the dynamics of contagion from the US low grade asset-backed securities (ABSs) market to UK financial markets during the 2007 subprime mortgage crisis and identify the contagion channels using both a single-state vector autoregressive (VAR) model and a Markov-switching vector autoregressive (MSVAR) model. We show that a shock to the US low grade ABS market results in a significant and persistent effect on the yields of UK financial assets, which demonstrates the existence of contagion. Moreover, contagion episodes mainly occur during periods of financial crisis. We also find that the contagion effects of the US lower grade ABS market are transmitted to UK financial markets through a number of channels, including flight to liquidity, risk premium, flight to quality, and correlated information.