The subprime credit crisis and contagion in financial markets

I conduct an empirical investigation into the pricing of subprime asset-backed collateralized debt obligations (CDOs) and their contagion effects on other markets. Using data for the ABX subprime indexes, I find strong evidence of contagion in the financial markets. The results support the hypothesis that financial contagion was propagated primarily through liquidity and risk-premium channels, rather than through a correlated-information channel. Surprisingly, ABX index returns forecast stock returns and Treasury and corporate bond yield changes by as much as three weeks ahead during the subprime crisis. This challenges the popular view that the market prices of these toxic assets were unreliable; the results suggest that significant price discovery did in fact occur in the subprime market during the crisis. (C) 2010 Elsevier B.V. All rights reserved.