The Subprime Asset-Backed Securities Market and the Equity Prices of Large Complex Financial Institutions

Abstract

In this paper, we investigate the linkage between the subprime asset-backed collateralized debt obligations (CDO) market and Large Complex Financial Institutions (LCFIs). We attempt to account for the dynamics between the ABX index returns and the banks’ equity returns through conditioning our analysis on the historical correlation between the variables. Three key results emerge from the analysis. First, we find a positive correlation between movements of the ABX index and the equity returns for all the LCFIs. Second, the volatility of ABX index returns tend to be transmitted to the volatilities of the equity returns of the financial institutions. Third, we find strong evidence of contagion effects to the European-based LCFIs. Overall, a two-way linkage emerge for the US LCFIs.