Introduction

The financial crisis of 2007 is described as the most severe one since the Great Depression. Its initial effect on the economy is somehow comparable to the crisis of 1930, but one can only guess at the secondary effects. In 2007 financial markets underwent very large losses and the crisis was triggered by decrease in prices in housing market and subsequent threat of defaults of banks with large mortgage exposures and subprime borrowers. In the beginning of the housing bubble banks had to write down billions of dollars in bad mortgages, and the stock market capitalization of the major players declined two times. This resulted in shrinkage of the structured credit market and credit crunch for individual and institutional lending. In 2008 the crisis spilled over globally, and also caused collapse or bailout of several major US banks Bear Stearns, AIG, Freddie Mac, Fannie Mae, Merrill Lynch etc. The US government launched unprecedented amount of liquidity and financial guarantees to the market, in order to avoid broader contagion and to halt the spillover effect to other markets. The current financial crisis has been explored from many different perspectives. There are many papers dedicated to previous crises, however the research for contagion in the financial markets in 2008 has been scarce. Thispaper explores contagion with a very specific dataset ABX-HE (Asset Backed Securities Index) indices. These are indices based on Collateralized Debt Obligations (CDOs onwards see next section) of asset backed mortgage securities. Since the beginning of the crisis was marked by the fall of real estate prices in the US, these indicesare very good benchmark of the financial events in the period 2007-2010.Longstaff (2010) analyzes the contagion effect and pricing of subprime CDOs. The author assumes that ABX-HE indices are proxies for CDO market prices and finds strong contagion effects between low and high rated sub-prime CDOs, which effects are then transformed to the stock market. The current master thesis closely follows Longstaff (2010) and explores the degree of contagion caused by ABX-HE indices of mortgage backed CDOs. Particularly it uses Vector Autoregressive Framework (VAR model onwards) to see whether ABX-HE returns are related to returns of other markets. Motivation behind the topic The main idea of this paper is to shed light on the degree of contagion which goes from the CDO market and is spread to the US and European stock and bond markets. The general focus of research is on US markets, but since the crisis spread through the whole world, it is important to see what the consequences are in other markets. Therefore the analysis extends to

Europe to see how the European market is affected. Financial markets are so interrelated, that a crisis in one particular country will inevitably spill over to other countries. Understanding the nature and degree of contagionin markets is of great importance. Despite that the process of contagion, to a large extent cannot be precisely predicted and controlled, it is important to study it, because many of the consequences can be mitigated if market players and governments intervene in the proper way and on time. This crisis is certainly not the last one to happen in the financial markets, and the best thing investors cando is to learn its lessonsand try not to repeat them in the future. Thissurveyshould contribute a bit more to the volume of research dedicated to contagion in financial markets and the current crisis. The paper closely follows Longstaff (2010), which analyzes contagion shortly before the crisis happened. The results of the study show large degree of contagion during the period 2006-2008. This master thesisextends the analysis to the period 2008 2010 in order to measure the secondary effect of contagion on the market after the event. Models are performed both on year-by-year basis and for the whole sample period in order to see whether contagion decreases through time.Longstaff (2010)alsoexamines the channels for contagion (see Literature review) but this issue is out of the scope of the current paper. The main issue concerning Europe is whether the negative expectations for the US CDOs are transmitted to Europe and how European CDO market influences the stock market. For models in Europe is used local CDO index iTRAXX (but not ABX-HE). The direct connection between US and European CDO markets is not examined, which is one limitation of the master thesis. The presumption is that European investors expectations, driven by the crisis in US, contaminate the European market for securitized loans, and then trigger a wave to rest of the market. Initial expectations are that CDO indices will show moderate degree of contagion which fades to the end of the sample period. General picture of the crisis In the period 2001 2006the subprime mortgage market experienced dramatic growth, which led to an increased volume of securitization of subprime instruments. According to Demyanyk and Van Hemert (2011), this triggered the crisis because investors who were searching for higher yields, kept on increasing the demand for mortgage backed securities. The authorsshow that during the growth phaseof mortgage backed market, loan quality deteriorated. The spread in subprime mortgage rates accounts for the increase in default risk, therefore it should have increased too. However they assert that this not onlydid not happen, but on the contrary, it declined. Loan quality was deteriorating for five years before the crisis,

but it was masked by the appreciation in housing prices, until in 2007 the true risk became apparent. During that period there was deterioration in lending standards and also a decrease in the mortgage rates. In general subprime lending is considered riskier than prime lending since subprime borrowers have poorer credit histories, high debt to income ratio, or lower FICO1scores, thus lenders charge higher interest to compensate for risk. This negative trend in loan quality could have been observed in 2005, long before the crisis began. However the governmental policy during that period stimulated distribution of loans to people with low to middle income with low to middle income class. Demyanyk and Van Hemert (2011) detect higher likelihood of delinquency in low and middle income areas, which associate with Community Reinvestment Act and/or Government Sponsored Enterprises, and their housing goals, and increased lending with the initiation of low quality lending. The Act is the core of that government policy for distribution of loans for housing purposes. Interest rates should have respondedaccounted to the higher risk, but obviously it did not happen. For a relatively long period of time before the start of the crisis, the US economy enjoyed low interest rates. After the internet bubble burst in the mid 2000 The Federal Reserve cut the FED funds rate, the key short term interest rate from 6.5% to 1% and injected huge liquidity. Ben Bernanke followed the policy of Alan Greenspan and further fuelled the system with liquidity which is one reason for the ongoing crisis. According to Arestis and Karakitsos (2009)the excessive liquidity that is put in place for the last decade triggered most of the bubbles. Liquidity first financed the internet bubble and excess liquidity helped fuel housing and commodity bubbles.Apart from the loose monetary policy, two other factors influenced the high liquidity financial liberalization and innovation in financial engineering. Two reasons can be given for the low interest rates (loose monetary policy). The first one is large external capital inflows (mostly affects long term interest rates) - Asian countries pegged their exchange rates and were buying US securities to hedge against depreciation of their own currency against the dollar. The second reason is the Federal Reserves lax interest rate policy (affects short term interest rates). New economic policies all over the world which are focused at the nearly total demise of fiscal policy and emphasis on interest rate changes as a vehicle to control inflation (Arestis and Karakitsos (2009))aidedthe crisis spillover. At the same time there was a large scale transformation in the banking system. The

FICO (Fair Isaac Corporation) scores measures the credit risk of individual borrowers based on a statistical analysis of their credit files. FICO score ranges between 300 and 850 and subprime loans are often defined as those to borrowers with limited income and/or score of 620 or below. Fender and Scheicher (2008)

financial liberalization which started around 1970 brought many innovations and the most important was that financial institutions enabled banks to dispose of their loan portfolios in accordance with risk management, by using interlinked securities and complicated derivatives. The traditional model in which banks issue loans and hold them until they are repaid evolved to the so called originate and distribute2 model, where pools of loans are tranched and then sold via securitization which further enhanced external capital inflows. This financial innovation is connected with the issuance of CDOs and CDSs and helped transferring risk to those who were most willing and able to bear it, and triggered unprecedented credit expansion, thus fueling housing price increase(Brunnermeier and Pedersen (2009)). As will be discussed later, structured products can spread risk among many market participants. This not only allows lower mortgage rates, but also enables institutional indirectly buy assets which are not banned for them. For instance pension funds are allowed to invest in AAA rated fixed income securities, but can also buy an AAA rated portfolio with lower quality securities. This practice creates even more risk for the financial system, since the level of risk stays artificially low. The more problematic outcome is that the credit risk does not shift from the banking system since the most active investors in structured products are investment banks. Regulatory standards for financial institutions did not play their role. Basel 1 accord required banks to hold 8% capital of the loans on their balance sheets, around zero3for contractual credit lines and no capital for credits with high ratings. Basel 2 required levels of capital based on asset risk ratings, but banks pooled the loans in their Special Purpose Vehicles (SPVs) where, because of better diversification the loans received better ratings and thus require almost no capital. The possibility to shift risk led to a flood of cheap credits since banks were facing risk just for some months, till the time they form and sell the tranche. Furthermore they did not have the incentive to monitor loans. Keys et al. (2010) provides evidence that securitization led to lower credit quality. Brokers of mortgages offered low rates and demanded no documentation, based on the assumption that house prices could only raise. After the introduction of the US Glass-Steagall Act in 1999, banks were no longer concerned about the three Cs of borrowing Collateral, Credit history and Character. The provisions of the act removed the separation between investment and commercial banking, which led to extreme growth of
2 3

Brunnermeier and Pedersen (2009) Basel 1 considered CDOs as a portfolio loans sales and banks face 0% capital requirement

loans to borrowers with bad credit history and questionable value of collateral, or the so called subprime market. Banks could easily sell these mortgages in the form of CDOs to external investors, creating the US housing bubble. Despite of that, the subprime mortgage market worked very well over the period 1998 -2007, which will become obvious from the following analysis. In the early 2007 many researchers were concerned about the growing bubble (Berman (2007)), but were somehow optimistic, or as Abreu and Brunnermeier (2003) assert found it more profitable to ride the wave than to bet against itThe first clear signs came in February 2007 with the increase of subprime mortgage defaults. Filing for bankruptcies fallowed subprime lenders fire sales, and write offs of assets. Appendix 1 presents Figure timeline of the crisis. Contagion in Europe Adrian and Shin (2008)asserts that exposure to the subprime sector is small relative to the total size of the balance sheet and to the total capital held by financial institutions. According to the domino model which they propose, defaults of subprime borrowers should be easily absorbed from the financial sector and securitization would further ease the process. However, the domino model of financial contagion is not relevant for the world. Financial institutions are not passive; in practice they anticipate default events and take actions. The model also does not take into account price movements triggered by risk changes. In practice price changes affect balance sheets much more than defaults. Defaults do not necessary bring contagion, but prices do. Financial institutions balance their portfolios actively and since market events are simultaneously reflected in prices synchronized reactions lead to tremendous shifts of values. Most financials argued that the total size of credit exposures is relatively small. According to Adrian and Shin (2008) the total amount of outstanding adjustable-rate subprime mortgages is less than $1 trillion. Mortgages originating in the period 2006 2007 are small fraction of the total. Assuming that subprime default rates rise to unprecedented levels the total losses should be around $200 billion, which is negligible amount compared to $58 trillion value of US households. Bearing in mind that most of the loans were securitized (so the impact of possible shocks has to be spread among number of diverse parties) the shock would have to be much smaller. Beltran et al. (2008)evaluate foreign exposure to US asset backed securities. They state that despite of the large foreign exposure to US ABS, losses arising from the underlying assets are small relative to most scale variables. InAugust2007 investors reassessed the quality ofasset backed securities and this triggered the financial crisis in Europe. It came out

that European banks held large share of risky US securities. The authors assert that foreign exposure is only 22% of US securitized loans. If accurate, thefollowing analysis will not show high degree of contagion in Europe. However this paper does not study the direct relationship between European and US markets, i.e. whether ABX-HE indices contaminate European banks. Dwyer and Tkac (2009)raise the question whether problems in Europe and the rest of the world are entirely due to their large US exposure. According to the authors this claim is not true since the surge and subsequent fall in housing prices were worldwide events. Another reason they point tois that borrowers in countries such as the U.K., Australia and Ireland were not financing their houses by obtaining subprime mortgages from U.S. lenders. Despite of that, it appeared that many European banks have exposures to US CDOs for investment purposes. In the late 2007, though different mechanisms, theUS crisis spread to Europe. The first bank to be in serious distress was the UK-based Northern Rock. In July 2007 German IKB was the first bank in Europe to be bailed out. The group received a 3.5 billion euro rescue package. On August 9 French-based BNP Paribas announced inability to value structured products. At the same time two banks in Germany failed into financial distress due to their subprime investments (Reuter (2007)). The same happened to two towns in Norway with exposure to asset backed commercial paper from. The crisis in Europe transformed to a debt crisis for the governments of highly indebted countries Greece, Ireland, Portugal, Spain and Italy. The remainderof research is organized as follows: next section presents review on financial contagion literature, together with different approaches of research; a description of CDOs and CDO, together with characteristics of the ABX- HE indices follows; next is data section together with models and methodology; finally results are discussed and the last section concludes.

1. Literature review
Discussion on financial markets contagion is very broad. Financial markets are so interrelated, that a crisis whether in the banking sector, foreign exchange market, or external debt market has a spillover effect to all the other markets. In the early 1978 Kindleberger (1978) in his work Manias, Panics and Crashes called this effect international propagation. In literature of the new century the phenomenon is described by the term contagion.

Dornbusch et al. (2000) provide an extensive overview of the existing definitions. Sachs et al. (1996) define contagion as all unexplained turmoil.This definition is found to be incomplete and too broad for the purposes of empirical studies and is rarely used. Edwards (2000) considers contagion as the information transfer among markets which exceeds ex ante expectations. Hoffmann (2000) defines financial crisis as lasting disturbances of capital markets. These crises can be banking, external debt, and currency crises. In almost all of the cases these forms cannot be disentangled and are interlinked with one another. One form can be preceded by another. Investment, liquidity, trade and exchange rates are important channels for the spillover effect of the financial crises. International Monetary Fund adopted the definition from Masson (1998). Masson (1998)investigates contagion in currency markets, by modeling movements in exchange rates in combination of country specific events, multinational events which have an impact on all markets (monsoon effects) and spillover effects. Movements in exchange rates, unexplained by these three factors, is contagion. The definition accepted by the World Bank is similar: contagion exists when cross-country correlations increase during crisis times relative to correlations during tranquil times.Longstaff (2010) adopts the definition of financial contagion: an episode in which there is a significant increase in cross-market linkages after a shock occurs in one market. This definition will be used for the current analysis. Studies and theories of contagion There is very extensive research dedicated to contagion, its causes and effects. Important recent works include Allen and Gale (2000), Allen and Gale (2004)Brunnermeier and Pedersen (2005). Allen and Gale (2000) provide a model with microeconomic foundations for financial contagion. Banks have cross holdings of deposits in many regions, and if a financial shock appears they liquidate them. According to the authors, small shocks in the system can lead to tremendous effects by means of contagion. Several opinions exist about financial crisis emergence. According toKindleberger (1978) they are completely random events, with no relation to real economy. Schwarcz (2009) refers to Chaos theory which posits that small collapses can enhance the stability of complex systems the way an area of tectonic activity might produce thousands of small tremors in order to avoid a severe earthquake. The theory of complex systems failures posits that crises are inevitable. In that sense Allen and Gale (1998)and G. Gorton (1988)assert that crises are integral part of the business cycle. The authors assume that contagion is driven by shocks and

linkages between regions, and it is not a random event or sunspots. They find that investors who suffer losses in one market and are not able to find funding are brought to a downward spiral in market liquidity. Kodres and Pritsker (2002) explore cross-market rebalancing during crisis. The authors find that when agents face losses in one market, they rebalance their portfolio and this causes price co-movements. Countries in which asset values are driven by common macroeconomic factors are extremely vulnerable to cross-market form of contagion. When external trading is misinterpreted as related to information about asset values of that particular country contagion spreads very easily. Asymmetric information makes all countries vulnerable.Cipriani and Guarino (2008)show that informational spillovers across markets can have long lasting negative impact onprice behavior. According to their model, when agents are heterogeneous, informational cascades arise information does not flow to the market and values move from fundamentals. History of trades of one asset can affect the price of other, which creates correlation between assets prices in excess of the correlation between the fundamentals. After an extensive analysisBackus et al. (1999) conclude that a crisis in banking industry also spreads contagion in securities markets, since there is enough liquidity supply in the market and market prices reflect real prices. When there is a small scale crisis, the prices of risky assets fall, followed by a liquidity crunch and contamination of other assets. The authors speculate that government can be better off if it looses monetary policy early in case of contagion in a country. They also assert that closing banks and immediate recapitalization can have deeper consequences for liquidity and worsen the problem. Special attention should be paid to the disclosure of derivative trading and other off-balance-sheet trades which imposes great risk. Imperfect or no information also brings to the contagious effects of a crisis.Rochet and Tirole (1996)assertsone bank failure means that it had not been monitored properly, also risk that other banks have not been monitored too, investors withdraw and collapse occurs. If a bank creates difficulties for other banks, the model predicts that the central bank will assist all solvent lenders who are about to fail because of their interbank relations with the problematic bank. Bae et al. (2003) find that contagion is more prominent among developing countries than in developed ones. Furthermore Kodres and Pritsker (2002) find that developed countries tend to contaminate developing ones with their trading behavior during crises.Calvo (1999) presents a model where leveraged needs to sell assets in order to finance credit. Because of information asymmetries the price of asset drops and the investor instead sells other holdings in the

portfolio. As a result their prices fall too and thus contaminate markets.Bikhchandani et al. (1992) explore reaction of mass behavior during informational cascades: An information cascade occurs when it is optimal for an individual, after observing the actions of those ahead of him, to follow the behavior of the preceding individual without regard to the individuals own information. The author states that cascades often have negative consequences for most of the individuals, and lead to tremendous swings of herding behavior without any particular reason. In the same sense Banerjee (1992) examines herd behavior, or why are people doing what everyone else is doing, even though they have private information which suggests different scenario. This behavior leads to excess volatility in markets, possibly to a crisis and then contagion to other markets. Calvo and Mendoza (2000) claim that global diversification of portfolios and informational asymmetries lead to contagion in international markets. Herding is also present here when all investors follow the same portfolio. Nurkse (1944) suggests a story of voluntary contagion where currency devaluation in one country (which leads to higher exports) will pressure other country to devalue too in order to improve its current account. Contrary to previous research, Allen and Gale (2004) argue that financial crises are not bad phenomenon from a welfare point of view; rather they are essential for constrained efficiency. How contagion is spread Longstaff (2010) asserts there are three different channels through which contagion is spread correlation channel, liquidity channel and the risk premium channel. Extensive body of literature is dedicated to trade links (correlation) as channels of contagion. Eichengreen et al. (1996), Glick and Rose (1998), Kaminsky et al. (2003) prove that trade links explain contagion in industrial countries using different sample periods. Kiyotaki and Moore (1997) use a model in which the impact of illiquidity at one link in the credit chain travels down the chain. Small and temporary shock in a system of firms which borrow and lend to each other may cause a chain reaction after which large number of firms get into financial difficulties.Allen and Gale (2000), Brunnermeier and Pedersen (2009)share the view of Kiyotaki and Moore (1997)that contagion is spread through liquidity channels.This implies that a distress event may be followed by subsequent declines in availability of credit and transfer to trading activity in different markets, which can last for long period of time. Calvo (1999) employs a model of contagion through liquidity in one market. Investors liquidate assets in other markets, because they need additional collateral or cash to fund investments.So liquidity is correlated with volatility. Frank et al. (2008)explore the linkage between market

and funding liquidity at crisis of 2007 as a transmission channel for contagion using GARCH model. The findings suggest that market and funding liquidity interacted very intensively during that period. Cifuentes et al. (2005) assert that fire sales of assets feed volatility and result a downward spiralin asset prices which have adverse effect on financial institutions. The authors state that under some circumstances regulations can have negative effect on the stability of the financial system. Because financial institutions do not internalize the externalities of network membership, banks liquidity choices will be suboptimalliquidity requirements can internalize some of the externalities that are generated by the price impact of selling into a falling market. Backus et al. (1999) use a model based on bank runs which explains how a crisis can happen in the banking industry and spread contagion to other markets. They argue that liquidity crunch and imperfect information are the main reasons for contagion. A crisis can be initiated either by an economic slowdown or if some bank experiences a cost-efficiency shock. During the crisis the degree of contagion depends on the liquidity demand and supply. When supply is not enough liquidity crunch happens and assets market price falls. This affects healthy banks in two ways first their consumers withdraw early and second their investments decrease. Brunnermeier and Pedersen (2005)describe how contagion spreads through so called predatory trading (risk premium channel)where investors who are in need to reduce their positions sell assets. However other investors also sell and immediately buy back at lower price, which leads to reduced liquidation value of the distressed traders assets. This triggers distress in another trader, makes markets illiquid, enhances systematic risk and causes the crisis to spill over. Their analysis supports intervention by regulations in times of crises. Longstaff (2010) elaborates on the empirical implications and behavior of those channels, but this analysis is out of the scope of the current writing. The author clearly states that contagion in 2007 was transferred through liquidity but not correlation channel. Cifuentes et al. (2005) employ a model which considers two channels of contagion through balance sheet interlinkages and through changes in asset prices. A shock in the market value of a firms balance sheet can result in fire sales, causing a further short term drop in price. This can lead to insolvency and contagion to other assets. The most important implication from the paper is that regulation such as Basel in combination with mark to market rules can generate spilloversto financial institutions. Marking to market enhances transparency but during a potential crisis, becomes a channel for contagion. Kodres and Pritsker

(2002)examine contagion through correlated information, and cross-market rebalancing of portfolios. They apply a rational expectations model to examine contagion, where asset values are predetermined by macroeconomic risk factors (both country specific and international). When investors react on country specific information, they rebalance their portfolios according to macroeconomic factors in other markets. Asymmetric information arises in other markets and causes excess volatility and contagion. This leads to the discussion of the advantages of different methods of studying contagion What are the different approaches used to explore contagion? The following classification of approaches is based on extensive literature review, but is not exhaustive. Pericoli and Sbracia (2003) divide studies in four groups, and this paper follows their model, but augmented with a few new approaches. The first group of empirical studies measures only the effect of a shock. In this group Probit and Logit models can be assigned. Lagunoff and Schreft (2001) explore the spread of crises with a probabilistic model. Financial agents are interlinked throughthe diversified portfolios they hold.This complicated linkage allows portfolio losses from one agent to spread through the whole financial system. However, compared to other models, here the agents do not know to whom they are linked directly and indirectly. They chose their portfolios and ignore the linkages. Also, the model does not consider market players and portfolios as static and myopic. They take dynamic decision problems and forecast future consequences of investments. The Model shows that the sooner the collapse of the system happens, the more fragile the system is. The authors also assume that a government can supply liquidity to the economy and reduce fragility. Probit and Logit models are also employed to the same ends by Eichengreen et al. (1996), Caramazza et al. (2000), Van Rijckeghem and Weder (2001). The second group includes studies which using the GARCH model to deal with transmission of shocks in financial markets. Hamao et al. (1990) apply GARCH framework and consider the short-term relations among security markets. The authors find spillovers from the US to UK and Japanese stock markets.Frank et al. (2008) model the linkages between market and funding liquidity during the 2007 crisis.Hesse and Frank (2004)explore linkages among developed and emerging markets using GARCH and find evidence of theco-movementsin financial markets going from the developed to the emerging markets. They suggest that spillovers have to be closely examined in light of the interconnectedness of global economy.

Hon et al. (2004) apply the GARCH model, but also present significant improvements over prior studies, showing that there is substantial heteroskedasticity in the data. Previous studies do not adjust their results for heteroskedasticity, causing false increases in the estimated results. Crises usually increase volatility of stock returns and induce false increases in the estimated correlation. The study also regards the interdependence of financial markets in two periods before and immediately after the crisis of September 11th. Correlations differ significantly in the two periods. After accounting for that, they find that there is no contagion in market co-movements, but only interdependence. The implication from the paper is that diversification works for investors only if global stock markets are stable and not correlated, and is useless in cases of spillovers or contagion. The third group comprises of studies which use Markov models for contagion: Ramchand and Susmel (1998) and Chesnay and Jondeau (2001). determination of the crisis period. The fourth group of studies is based on correlation breakdowns adopted by Baig and Goldfajn (1999). Correlations control for common sources of movements in stock prices before assessing changes in the information transfer process. Contagion examined through correlations between stock prices is the focus ofDungey et al. (2011) and King and Wadhwani (1990) which follow a model proposed also byForbes and Rigobon (2002). Frank et al. (2008)offer a Dynamic Conditional Correlation (DCC) specification (first presented by Engle (2002)). Significant changes in correlations between periods are considered contagion. Forbes and Rigobon (2002)show dramatic decrease in contagion after correction for According to Rodriguez (2007) an advantage of Markov models in studying contagion is that they do not rely on an ad hoc

heteroskedasticity. The main weakness pointedout by Stambaugh (1995)and also Forbes and Rigobon (2002)is heteroskedasticity or autocorrelation (the first and second moments of the distributions (mean and variance) are not stable over time) and if not corrected for that, results are false. Corsetti et al. (2005)show that if the variables are not iid (independent and identically distributed), the results remain biased. Studies from Horta et al. (2008) and McNeil et al. (2005) conclude the same concerning correlations and employcopula models.Horta et al. (2008) explore the degree and intensity of contagion to developed countries during the 2007 crisis. The authors employ copula models to examine the cross-market connections betweenthe US and other G7 markets. They split the sample in two periods pre crisis and crisis, and it appears that Canada is the country with highest degree of contagion whereas Germany is not that affected.Another positive feature of copulas pointed by Costinot et al.

(2000) is that they allow characterization of the dependence and also definition of the structure. Longin and Solnik (1995) use VAR model for estimation of contagion effects. In this approach different groups of financial market data are connected (Eun and Shim (1989)).Nagayasu (2002) tests for contagion in stock markets in the Philippines and Thailand. He employs VAR methodology and finds Ganger causality between exchange rates and some sectors of stock price indices. Khalid and Kawai (2003) also use multivariate VAR model. Their survey does not find strong support for contagion in the Asian region in 1997. Boschi (2005) tests the hypothesis of contagion during the Argentine financial crisis in 2001 with a VAR model, but also finds no contagion. Bazdresch and Werner (2000) study contagion in Mexicos financial market during the Asian and Russian crises. Authors find contagion, although weak. The reason to use VAR as a primary model for the current study is that it identifies causal relationship among several different variables stock, bond and CDO markets in this case.Here add more reasons and pros and cons for VAR All kinds of surveys on contagion agree on several important features. There are unobservable factors which affect the markets. Another aspect is that to a certain extend these factors are structured. In most of the studies there is a link to Massons finding that movements in financial variables should be linked to changes in country specific events and common shocks (Forbes and Rigobon (2002)). This provides evidence for linkages between markets. In the next sections the general structure and process of formation of CDOs and also the default insurance contracts called Credit Default Swaps (CDS) is explained. It is important to understand how they are formed, since ABX-HE indices are based on CDS.

2. Asset backed CDO market

To offload risk, banks create structured securitized products called Collateralized Debt Obligations (CDOs). Longstaff and Rajan (2008) present an extensive overview of CDOs and its mechanisms. A CDO issuer first forms a portfolio of loans by lending money or by buying bonds in the market. If asset-backed, these securities can consist of mortgages, loans on manufactured homes, auto loans and account receivables. Mortgages are pooled according to priority in receiving payments from them and notes are issued against these pools. The notes have ratings from credit rating agencies. The issuer forms a portfolio and sells CDO tranches based on cash flows which have to be generated from the underlying loans. The portfolio is

transferred to a special purpose vehicle (SPV) which represents financial entity owned by the issuer and is some form of intermediary (collects principal and interest, and distributes cash flows). Tranches are sold to different investor groups which have different receivables. Most senior tranches have first claim on interest payments. The safest one (super senior) has low interest rate but has priority payment from the cash flows of the portfolio. The riskiest tranche (called toxic waste) is paid only after all other tranches. There is also mezzanine tranche which is in between. The advantage of the CDO is that it allows the issuer to repack the current loans and sell them to third parties. Thus the issuer can earn fees from servicing the loans and at the same time obtains fresh capital for new loans. This practice creates a moral hazard problem since the issuer bears very little risk of the losses. CDOs allow separation of risk and funding, but also create potential agency problems. By buying insurance for risk, lenders lose their incentive to monitor companies. The protection seller cannot monitor the firm in the same way, which leads to incorrectmarket assessment of firms credit risk. CDOs based on the portfolios of subprime home equity loans were the initial credit losses for many financial institutions. Subprime mortgages have significant default risk and CDOs were issued in large quantities during the past several years. Buyers of the tranches can protect themselves by purchasing credit derivatives. Beltran et al. (2008) offer a good scheme of the process of securitization. Securities are issued by SPV, which in turn can issue short-term asset-backed commercial paper (ABCP) to finance the purchase of CDOs. Figure 1 shows the process of creating various types of securities. Each stage may be undertaken by different entity and can include new securities from many large varieties of assets. Key assumption which the authors make is that market participants have less information of the underlying assets after further securitization. An investor holding a CDO can observe only the price of the ABS underlying that CDO, but cannot observe the mortgages one step behind. Again it should be noted, as has been done by Backus et al. (1999), that CDOs trading and other off balance sheet trades impose great risk because of lack and information back in the chain, and those operations also can bring contagious effects. The study from G.B. Gorton (2009) will be considered in the next section, but here it is worth to note one drawback from his work namely that the complicated structure of ABX-HE did not allow investors to see the specific group of toxic CDOs and this causeda loss of confidence. Beltran et al. (2008) find evidence that CDO prices during the crisis were marked down more than the prices of the underlying loans themselves. Asymmetric information is making CDO

prices swing more both pre and during a crisis: pre-crisis investors underestimate the risk carried by the underlying loans; once the crisis begins, investors overestimate that risk.
Figure 1 - Process of generating securities by repacking

Original loans

Trust certificate

Traditional ABS

CDO

Asset backed commercial paper

As it is already mentioned, buyers of securities can also purchase insurance against CDO default by using Credit Default Swaps.

3. Credit Default Swaps

Credit default swaps (CDS) are contracts that ensure investors from default of particular tranche. In their simple form CDS are a type of financial derivative. With credit derivatives one can buy protection without buying the underlying instrument. CDS can be used to insure portfolios of subprime mortgages, or their securitizations (CDOs). It has to be noted that according to Allen and Carletti (2006), credit risk transfers are useful because they help to share risk. However the authors also prove that CDSs can bring contagion and cause financial crises. During the boom preceding the 2007 credit crisis, the demand for exposure to subprime mortgages grew faster than the mortgages themselves. Banks were not able to create enough tranches, and this was impetus for investors to create such exposure synthetically through CDS. There is no outstanding supplier of CDS for each protection buyer there is a protection seller. CDS are traded on the OTC market, which is not regulated, and there is no official market size data. The Bank for International Settlement provides statistics for the CDS market since the end of 2004, but only based on survey data4.In the beginning of 2004 the notional amount is $6 trillion and in the middle of 2008 the size is $57 trillion, which is close to a ten- fold increase. However, the size sharply drops after the first half of 2008 and at the end of the year it is $41 trillion. In the middle of 2010 the estimated value is $26.3 trillion. According to many analysts, CDS contributed significantly to the crisis and were the initial cause for the collapse of banks, the housing prices fall and the 2007 credit markets freeze point three reasons why CDS were the main cause for the crisis. First, CDSinitiated the credit
4

http://www.bis.org/statistics/derstats.htm

boom; second the large exposures of financial institutions to those instruments created synthetic risk; and thirdthe whole picture led to a crisis of confidence in the financial system. However, the CDS market, in many aspects,worked very well during the crisis. From 2007 to late 2008 it remained highly liquid because of the higher level of standardization compared to other bonds (payments and settlements are defined by ISDA5). Another reason for the good CDS market functioning is that investors can take short positions at a low cost and also go long without cash payments. Furthermore, the market remained fairly stable after the first extremely large defaults. For example, settlement of Lehmans contracts whose notional amount is unclear) went very smoothly. The graphs below show CDS spreads which is the annual premium an investor has to pay to insure a bond against default in percent of the notional amount. The Charts 1 and 2 show spreads of US and European financial institutions

http://www2.isda.org/

In 2006 indices of CDS written on CDOs were issued. These indices are called ABX-HEand represent a pool of CDS on securitized subprime mortgages. The first ABX-HE index began trading on 19 January 2006. Before the financial crisis began, all ABX-HE indexes were relatively flat with minor spreads.

1. ABX-HE indices
ABX-HE indices are innovation in response to the demand for tradable financial instruments as represented by CDOs, since CDOs are traded over-the-counter. Early reviews were provided by the research departments of investment banks (see Sinha and Chabba (2006) and Choudhry (2006)). Fender and Scheicher (2008) and Lehman Brothers (2006) present a very thorough survey on the mechanisms of ABX-HE. The following lines summarize those surveys and of course comprise only of the information in the scope of the current writing. The indices consist of series of equally-weighted, static portfolios of CDS, or more precisely the prices of subprime residential mortgage backed securities (RMBS). Growing volumes of subprime mortgages has increased the default risk and eventually triggered demand for financial instruments that enable investors to hedge the risk. Market participants can trade credit risk without entering multiple swap positions and even without having to own or borrow the underlying obligations. There is no physical settlement in the arrangements of the contracts. The buyer (called protection buyer) pays the seller (protection seller) an initial upfront fee of par minus the observed market price of the ABX-HE index plus a monthly premium called fixed leg. This premium is fixed until the expiry date, when the notional balances of the obligations are fully amortized, defaulted, or prepaid. Accordingly indices with reference obligations with lower ratings have higher fixed premia. The indices follow a pay-as-you-go structure in which the seller pays the buyer amounts equal to the write-down or principal shortfall of the referenced obligations called floating leg. This structure is different from the cash settlement where the seller has to pay the full notional amount of the obligation to the buyer in case of credit event. Protection sellers of ABX-HE indices have position that is equivalent to long position in the underlying reference credit. The motivation behind the position of the buyer may be negative expectations on the subprime mortgage market, hedging objectives, or arbitrage opportunities arising from pricing inefficiencies between cash and derivatives markets. Every six months new series of ABX-HE indices are introduced and each of these series includes 20 new subprime RMBS deals made during the previous six-month period. Each

index consists of five individual subindices, which reflect exposures to the same 20 underlying subprime mortgage securities with different ratings of liability structure. The underlying RMBS are selected based on set of criteria. The deal size must be at least $500 million and the average FICO score of the borrower must be 660. Each obligation has to carry ratings at a corresponding level by both Moodys and Standard & Poors. There could be only four deals from the same originator, and no more than six deals by the same servicer. Therefore the ABX-HE indices capture only part of the RMBS. Maturity of each ABX-HE contract corresponds to the longest maturity of individual CDS contracts in the index basket (the underlying deals have maturity around 30 years) and the average life for referenced subordinated tranches must be 4 years. Therefore the exposures are very similar to those of the underlying RMBS tranches. For example ABX-HE 06-1 AAA index consists of securities rated AAA from a pool RMBS originated in the second half of 2005. Accordingly the other subindices are based on tranches of the same securities with AA, A, BBB and BBB- rating. Since the AAA rated tranches in ABX-HE AAA index tend to be selected from the longer duration AAA positions, the index is not at the top of the capital structure of the RMBS pools. Therefore, the bonds have more interest rate and higher default risk than the shorter tranches. After initiation, index composition remains static. This implies that the underlying credit quality can deteriorate, but the instrument stays in the same subindex. Prices are quoted as a percentage of par for each individual index (Lehman Brothers (2006)). Ifan ABX-HE index trades below par, the cost of default risk protection has increased since the issuance date of the index. For instance when the price is quoted as 80% of par, the protection buyer would have to pay the protection seller a fee of 20% of the notional amount in addition to the monthly fixed premium on the index. Prices reflect investors demand for default protection of underlying subprime loans. The terms and coupon payments of the underlying CDS contracts are fixed (Gorton (2009)). The premia or discount relative to par defines the amount which will be exchanged. Indices allow short sellers to take direct and large positions on the mortgages and individual banks in the sector. Also bets on portfolio performance on the underlying securities can be made, because the underlying securities are known. There is no source of information for the short selling bets on ABX-HE indices, but it is interesting to point that these positions delivered two of the largest payouts in financial history. Paulson & Co. funds $12 billion in

profits from subprimebets based on ABX-HE indices in 2007 and Goldman Sachs around $4 billion of profits. Market makers for ABX-HE indices are investment banks. Those banks use the indices to hedge their sub-prime residential mortgage risk, and make bets on the future performance of subprime mortgage backed securities6. The indices are created and managed by Markit7 . Each participant is obligated to provide prices periodically. Various insurance companies, like AIG, provided protection on subprime risks. Unfortunately the group had to be bailed out, because it turned out that the company was not able to bear these risks. A default of a dealer has potential to create financial distress in the markets. There are several reasons for that writers of protection on the dealer will make losses, counterparties have to replace the contracts they have with the dealer in default in order to keep their exposures unchanged, and also there is limited transparency for the exposures of the dealers. In general, a failure of a financial institution leads to contagion among its counterparties (Stanton and Wallace (2009)). Some researchers assert that indices were the major reason for the current crisis. According to G.B. Gorton (2009)the plummet of ABX-HE indices revealed the shock to the valuation of subprime risk but it did not reveal where these risks residedand that uncertainty caused a loss of confidence in credit. In other words the construction of the indices did not allow investors to concentrate on specific groups of CDOs, or even to the subprime credits they comprise of. This led toa loss of confidence and subsequent panic in the market. There are also other theories for the causes of the subprime mortgage meltdown for example, rating agencies conflict of interest. This view is supported by White (2009),who states that Moodys, Standard & Poors and Fitch were the major culprits for the 2007 financial crisis. Rating agencies have contributed to more favorable ratings of CDOs versus corporate bonds. This happened with the helpof banks, which worked closely with rating agencies and ensured that tranches default risk was always a bit more than the level of corporate bonds. On the other hand, White (2009), Acharya and Richardson (2009) assert that the role of rating agencies is overestimated, since almost all securities were purchased not by investors but by banks. Instead of acting as intermediaries between borrowers and investors by transferring the risk from mortgage lenders to the capital market, banks became primary investors.
6

The sixteen investment banks in the consortium, CDS IndexCo LLC, included: Bank of America, BNP Paribas, Deutsche Bank, Lehman Brothers, Morgan Stanley, Barclays Capital, Citigroup, Goldman Sachs, RBS, Greenwich Capital, UBS, Bear Stearns, Credit Suisse, JP Morgan, Merrill Lynch, and Wachovia Stanton and Wallace (2009) 7 http://www.markit.com/en/

During the crisis, subprime RMBS were severely hit. The index for the second half of 2007 (ABX-HE-2008-1) was not issued due to insufficient RMBS trading and no subsequent index has been issued afterwards. Only four indices have been issued: ABX-HE-2006-1 (issued in January, 2006); ABX-HE-2006-2 (issued in July, 2006); ABX-HE-2007-1 (issued in January, 2007); and ABX-HE-2007-2 (issued in July, 2007). Despite of the global collapse ofthe RMBS, the market for ABX-HE indices remain important subprime mortgage securities benchmark. Fender and Scheicher (2008) find that market liquidity co-varieswith the returns on ABX-HE indices. Many investors continue to use the indices prices asa benchmark of their portfolio holdings. MacKenzie (2010) states, the ABX-HE indices were and are a guide to the economic value of US subprime mortgage-backed securities. Market liquidity providers might have problems to stabilize market prices in a market, which does not react accordingly to supply and demand. Large portion of the ABS CDO securities are privately placed, which makes the market thin and more illiquid. Nevertheless the virtual market of ABX-HE indices was sufficiently large and liquid to react accordingly to purchases made by liquidity providers. A potential investor could invest in ABS CDOs without owning them and without a limit of the amount. Liquidity of CDS indices is higher than the CDS themselves. Taking into consideration the large volume of trading ofthe ABX-HE index (according to Reuters, the indices price more than $1 trillion of MBS), there is scarce research focusing on the price dynamics of the indices and their influence. This could be due to the fact that these indices are comparatively new to the market.

1. Data description
The sample research period is 2006 2010; as for US indices the first year is 2008. The primary focus of this master thesis is ABX-HE indices and their influence on stock and bond markets. In the previous section there was an extensive review of ABX-HE indices. The ABX-HE-2006-2 (issued in July 2006) is chosen for the current analysis for two reasons. First, there are differences in the availability of the different indices in Datastream. For instance, ABX-HE-2007-1 is available for all ratings but not for AAA and BBBM the same is the case for the other indices. ABX-HE-2006-2 is the index available for all ratings. Second, a preliminary analysis performed with multiple indices from the same rating (for instance AA for all the years) showed approximately the same coefficients in the models. It should be noted that if all AA indices are plotted in a graph they co-move, but the more recent indices decrease more. Furthermore MacKenzie (2010)points, first to be affected were the BBB rated tranches of ABX-HE-06-2 indices, so one could expect that they are most sensitive (Chart 3). iTRAXX Europe 7Y - CDS Premium MID is an index licensed by Markit. It consists of 125 investment grade rated European entities and all of them are equally weighted. The 135 entities are from the following industries: Autos (10), Consumers (30), Energy (20), Industrials (20), TMT (20), and Financials (25). Each year new series are introduced in March and September. Before the explanation of results, it has to be noted that interpretation of coefficients for Europe is different compared to that for the US. iTRAXX Europe 7Y - CDS Premium MID is composed in a different way. The index presents the premium paid on CDS in Europe. The higher the risk for those CDS is, the higher the premium will be compared to ABX-HE where the indices fall as risk increases. This trend can be seen well in Chart 3 where time series of ABX-HE and iTRAXX are plotted and is especially pronounced if ABX-HEAAA and iTRAXX are compared. S&P 500 (Chart 4) is maintained by Standard & Poors and comprises of the stocks of 500 US Large-Cap companies. Since 2005 the index is float weighted, meaning that it is determined by the amount of publicly traded shares. The index reflects various sectors in the US economy. S&P Europe (Chart 5) is calculated in Euros on a base weighted aggregate principle the level reflects the total market value of the stocks. S&P Europe is subindex of the S&P Europe 350 index family, which includes blue chip stocks from 17 markets, if they are among the largest in terms of capitalization. The methodology is the same, and the only differencefrom the S&P Europe 350 is that S&P Europe excludes Sweden, Switzerland

andtheUK. S&P 500 Financials index8 (Chart 4) is unmanaged and equally-weighted and consists of the common stocks of the financial sector of S&P 500 index. The included industries are banks, diversified financials, brokerage, asset management, insurance and real estate. The MSCI Europe Financials Index9 (Chart 5) measures performance of the financial sector in European developed countries (top 10 countries). The index is free floating and includes banks (50%), diversified financial companies (18.7%), insurance companies (26%) and real estates (4.9%). Data for corporate and government bonds AAA and BAA

Corporate bond yield, 10 and 1-year Treasury bond yields is obtained from Federal Reserve Bank of St. Louis10. The corresponding time seriesfor Europe are acquired from Datastream. All other indices are obtained fromthe Thompson Reuters Datastream database. All indices in models are used in returns, but not in real values (indices do not exclude dividends). In Tables 1A and 1B in the Appendix correlation coefficients and summary statistics of the variablesare presented. A short,theoretical explanation of the connection between the Treasury bond yield (1TBY) or The 10-year Treasury bond yield (10TBY) and the stock market should be madeto ease further analysis and interpretation. The longer the maturity of bonds is, the higher the yield that investors demand for their investment (since risk is higher).TheYield curve11 reflects investorsexpectations for the economy. Normally investors expecttheeconomy to grow in the future and the slope of yield curve is positive. Whentheeconomy is expected to slow down, the long- term yields falls below short- term yields and yield curve inverts (Estrella and Mishkin (1996b).Longer- term yields drop belowshort- term ones, which is controversial to normal relationship. According to Keen (1989), an inverted yield curve is a valuable predictor of arecession. Shortly before the start of the crisis (end of 2006 till the first quarter of 2007) 1TBY is higher than the 10- year Treasury bond. Afterwards,the US government pushed down short- term interest rates in order to stimulate theeconomy. Interference on the market for long- term bonds is not possible, and their yield continued to fall, but with a slower pace.

http://www.rydex-sgi.com/products/etfs/products/overview.rails?rydex_symbol=RYF http://us.ishares.com/product_info/fund/downloads/EUFN.htm

10 11

http://www.stlouisfed.org/ The yield curve is the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill. Estrella and Mishkin (1996a)

In line with this theoretical explanation,it might be that investors search a protectionfor their money and at the same time keep liquidity in the short term. This increasesdemand for shortterm Treasury bonds and their yield falls. However more explanatory power has the US government interference in the market. Yields are pushed down to stimulate short- term spending and therefore growth. When short- term Treasury bond yields are dropping, S&P 500 should be surging. Till the end of 2007 indices co-move, but after the US government intervention, which decreasedthe1TBY to stimulatetheeconomy, they kept on dropping at a constant rate, whiletheS&P 500 kept on fluctuating . Of course,market recovery is not immediate, so there is a general downward trend intheS&P 500, but with a slower pace thanthe1TBY. Since this analysis is based on a sample with initial date 2008, one should also expect negative relation betweentheS&P 500 andthe1TBY. Relation between the other variables is explained intheResults section. Next section presents themethodology and models of the current research.

2. Models and methodology

The research topic of this thesis is the contagion between stock and bond markets in Europe and US and howit is affected by the newly established credit risk transferring financial innovative productsfinancial innovative products for transferring the credit risk, the ABXHE indices (and the CDS index iTRAXX since it also represents the credit spreads oncorporations corporations). In order to establish this dependence,one needs to investigate numerous directions to clarify to the fullest extent the interlinkages among financial markets. There are many dimensions in which the dependency could be expended geographical region, representing the physical closeness and availability of many investment opportunities; or the different financial markets and possibilities since a typical investor is considering investments not only in commodities and cash but also interchangeablyinequities and bonds. This is why, first of all, one needs to consider how the credit risk transfer affects the equity and fixed income markets on a more general setting. Also, the geographical aspect is accounted for market interlinkages spread not only through financial markets but also through geographical regions, thus there will beaseparate focus on the US and European financial markets. The first stepis to define whether there is a connection among all the equity, fixed income and credit risk markets,as literature proposes,but the focus will be set on the mid- and possibly after-crisis periods. This step is already taken in the previous section, andnext section

elaborates more on this. As during the proposed timelinethetherisk aversion of the investors and financial institutions became obvious, the expectations are that in the crisis periods in particular all the involved parties were following closely news regarding credit risk and perhaps even overreacting to that information. Thus, the parameters to be estimated are expected to be significant and negative in the crisis period, indicating that the more tension there is in the credit markets,indicating higf- default possibility and bad economic condition, the lower the returns in all other markets. Fromacalculation point of view one should be concerned by the simultaneity of return movements in all the discussed markets. Therefore, in the second step, contagion effects will be investigated usingt VAR models. It will be used in major way in this case as it takes into account the simultaneity of financial decisions and agents perceptions. That is, if there is an event that causes a spike in the fixed income market, this should affect the equity market (e.g. through pricing by CAPM-like models). This,on the other hand,will have a definite influence on the perception how healthy a company or even the entire economy is, leading toaspike in the ABX-HE prices. Bearing this in mind, one needs to make up a model that covers those markets and accounts for the simultaneity of the actions. Thus, the most obvious choice is the VAR model. The general modelis:

This indicatesthat the returns in the different K number of markets are specified at the same time by the previous period returns of those markets and the R lags of the credit market proxy. The exogenous U variable is a general expression for the credit market variables in the US case it will be the CDO market measured by the representative ABX-HE investment grade indices with investment ratings ranging from AAA to BBB-; in the EU case it will be the CDS market by its representative iTRAXX index. The Y variables are the proxies of the other markets returns. They will include S&P500 returns, Moody`s AAA and BAA spreads over the 10TBY and the 1TBY changes in yields. The frequencies in which those VAR models are estimated also vary. In any case, both weekly and daily responses in the underlying perceptions areestimated. Those are chosen such as to cross check whether the results obtained from one method are not driven by the specifics of the data frequency the weekly data may underestimate the significance of the contagion as for some periods the investors are affected even hourly by the news coming from

the credit derivatives movements; daily data,on the other hand, may be driven by many other factors, unrelated to the credit markets and thus for periods outside the crisis might not estimate the relationship appropriately. The thirdstep is to consider the number of lags. The main criterion by which the best fitting regression is taken is the Akaike Information Criterion (AIC). Many regressions with different time lags on all variables are taken into account and the best one is chosen to minimize the AIC. This is performed for both US and EU markets, for the different ABX-HE indices available (e.g. one for AAA, one for AA, one for BBB-). The significance of the results is based on the performed t-test for the significance of the individual coefficients andF- test are usedfor the significance of the whole regression . All of the regressions are estimated on a yearly basis separately for 2008, 2009 and 2010 (for Europe the time span is 2006 2010). Regressions are done year-by-year to check the direction of changes of the contagion. The predictions are that initially the interdependence of the markets is moderate, the results are significant, but later on as the economy recovers, the credit risk should also become smaller. These predictions are based on the findings of Longstaff (2010), where contagion fades slowly after a peak in 2007. A potential issue springs up in this case the small sample size. The weekly sample taken by years includes at most 52 observations and the 2010 one has only 37 observations. This is in general too small to perform normal VAR without any corrections. with small sample size, the results could be biased. In order to be sure that one has the right estimated results, this issue must be considered. Thus, in the fourth step, when performing all the F-tests, they will be corrected for small sample biasby making the standard deviations of the estimated regressions larger and thus more difficult to pass the significance test. In the last step, autocorrelation should be checked. As in the main focus is financial data and as it is well investigated, this type of data is perhaps non-stationary since todays returns are partly explained by the returns yesterday. That is why an autocorrelation test is performed on the regressions. Once it has been proven that there is link between all of those markets there is a need to go a step further and make some implications of those results. Given that all of the above are estimated and the results are significantly showing contagion running from the CDO/CDS market towards the equity and fixed income markets, another interesting topic is to check whether given not only the magnitudes of the credit risk factors but also their direction is

contagious such that higher magnitudes translate into higher probability of lower equity and bond returns. The positive or negative direction of the equity, fixed income markets and Moodys corporate spreads should be explainable by ABX/iTRAXX indices, which is another way to measure the significance of the linkage of the separate markets. In this case a Probit model is considered as the direction of change in the credit factor loadings are estimated to explain the direction of changes in the equity and the fixed income markets returns. Another Probit consideredis not only the direction but also how the magnitudes of the credit risk affect the probability of having higher or lower returns. The first major Probit regressionis:

The U and Y variables are the same as before. The regression is also implemented in the same way. The m number of lags for the credit risk variable proxy and the k number of lags for the other markets variables proxies are taken as to minimize the Akaike Informational Criterion. The U variables are created in the same way. For all the data from before: S&P 500 returns, Moody`s AAA and BAA spreads over 10-year Treasury bond and 1-year Treasury bond changes in yields, new data is encoded which takes value of 1 when the change or return of the variable is positive and 0 if it is negative. Obtained are estimated from weekly and daily frequencies. The period range is however only one, namely the entire sample. Again there areanumber of different Probits estimated one for every credit rating of the ABX-HE investment index available. For the European iTRAXX index only one Probit is estimated as there is onlyoneindex available. This model indicates that the probability of observing positive/negative movements in the markets depends on the previous movements in the same markets and the size of the credit factors.

The second major Probit regressionis:

All settings for estimation of the last are as before with the only difference that at this point it is not the ABX-HE/iTRAXX returns per se that are exogenous but the returnsdirection. The

Y=1 variable indicates that it takes a value of 1 when there is a positive change in the general credit quality and 0 for a negative change. For model selection is used AIC; weekly and daily frequency estimates are obtained; the period is the entire sample;anumber of regressions are done one for every investment rating of ABX-HE index available and one for the iTRAXX index. This model takes into account that the probability of observing positive/negative movements in the markets depends on the previous movements in the same markets and the previous movements of the direction of the credit factors. All of the above regressions and estimates are performed for both US markets and European markets separately, since the region may contain different characteristics according to the various investors characteristics belonging to those regions. The next section represents results from the models for both samples US and Europe. It is organized in two parts as follows:. Thefirst partfirst part presents VAR models fortheUS (weekly and daily frequency) usingtheS&P 500 index as representative for the whole market. Then VAR results forUS (again weekly and daily frequency), but usingtheS&P Financials index as representative for the US financial sector. The same pattern is used forthe EuropeVAR model again for weekly and daily frequency. FirsttheS&P Europe index is used as to represent the whole European market (daily and weekly). Then the results for MSCI Europe Financials index (daily and weekly)follow to represent the Europe financial sectoras representative for the financial sector in Europe. The second par presents results for Probit models in US and Europe,in the same sequence. First US (daily and weekly frequency) are presented for Probit 1 and Probit 2 using S&P 500 index. Probit 1 and 2 follow, but only for the US financial sector (daily and weekly) represented by S&P Financials. Finally Probit 1 and Probit 2 output from Europe (daily and weekly) using S&P Europe index are shownpas well as the results fortheEuropean financial sector represented bytheMSCI Europe Financials index (daily and weekly) in Probit 1 and Probit 2. Since all VAR and Probit models are estimated both on year-by-year and for the entire sample periods for the US and Europe, the output comprises of many tables. The tables are included in the Appendix part.The nextsection starts with results for the US with weekly frequency. It should be noted that the main emphasis in analysis is on weekly samples of S&P 500, and S&P Europe indices. The other regressions aim to confirm/refute the main samples. That is why only the main tables are presented in the text and the others are in the Appendix.

3. Results
According to Forbes and Rigobon (2002) standard correlations estimates are biased when examining contagion.Correlation does not mean causality Here add some analysis based on the correlations and diagrams which is preliminary if there is positive correlation between the indices and stock market I would expect contagion

Results US 2008-2010 S&P 500 weekly For the entire sample of ABX-HE-A index (Table 2), the coefficient of explanatory variable is -0.36 (1% level) in Panel C. This result contradicts initial expectations, since if there is contagion in the market, the sign of the coefficient has to be positive12. In the same panel the first lag of 10TBY is 0.74 and significant at 1% level, compared to -0.84 and -0.74 for 1TBY first and second lags (significant at correspondingly the 1% and 5% level). Though ABX-HEA in Panel C is negative (which contradicts expectations for contagion), 1TBY loadings are still in line with three dimensional relations between 1TBY, S&P 500 and ABX-HE-A (see the Data section for explanation). According to the model, long- term Treasury bond yields are a good predictor of the stock market represented by the S&P 500 index. For each ABX-HE index, in the S&P 500 regression (Panel C) from the weekly sample the first lag of 10TBY is significant at least at 10% level with coefficients around 0.74. The same holds for 1TBY, where the first two lags are significant but with a negative sign. The 10TBY factor loadings are negative and significant in Panels D and E with values -0.07 (5% level) and -0.08 (1% level). In line with the results from Duffee (1998)13, albeit weak, the coefficients show that the long- term

12

If one looks closer in the article from Longstaff, more precisely in Table 4 in results section, there is discrepancy between the analysis he presents and the results in Table 2 from this survey. In 2007 Longstaff (2010) finds positive and significant coefficients of all ABX-HE indices, for 1TBY, 10TBY and S&P 500 index. The author claims that dependent variables in regressions co-move with different lags of ABX-HE index and thus he finds contagion in the market. But why then in Table 2 of this survey 1TBY and S&P 500 move in different directions? If they are driven by the same factors, namely ABX-HE indices, one should expect them to move together and therefore the signs of coefficients in Panel Cbe positive. In the last panel of Table 4 from Longstaff (2010), which depicts the output for 2008, the loadings of ABX-HE index in the regression where 1TBY is dependent variable are still significant but with different signs. This partly confirms the above stated analysis and refutes the discrepancy between the output in this article and Longstaff (2010). Since this analysis is based on a sample with initial date 2008, it is obvious that one should also expect negative relation between S&P 500 and 1TBY, but the link between 1TBY and ABX-HE indices is ambiguous. 13 Duffee (1998) finds that there is negative relation between Treasury bond yield and investment grade bonds yield spreads. The extent of decline depends on initial credit quality of the bond; the decline is small for AAA rated bonds and large for BAA rated bonds. Fama and French (1989) show that expected excess returns on corporate bonds and stocks move together and variables that predict stock returns, also predict bond yields and vice versa. They relate returns to business cycle and state that when business conditions are poor, income is low

Treasury bond yieldpredicts negative return of AAA and BAA corporate bond yields. However, in the current analysis this relation holds only for 10TBY and none of Panel B coefficients is significant. This pattern repeats for all panels where AAA or BAA corporate bonds are dependent variables. Insert Table 2 here In Table 3 (as in Table 2), ABX-HE-AA index is insignificant. In Panel C of Table 4 the ABX-HE-AAA loading of 0.24 (1% level) predicts that a shock in the index will cause a negative effect on the market. This result shows contagion which goes from CDOs to the stock market. A coefficient of 0.24 (meaning that for every percent increase/decrease in the CDO index there is a 24% increase/decrease in the stock market index) is not high but still this is a confirmation of the expectations for contagion and in line with Longstaff (2010). It is interesting that the stock market turns out to be most sensitive to the index with the highest quality. In Panels D and E ABX-HE-AAA factor loadings are with negative signs at -0.02 and -0.03 (significant at 1% and 10% level)respectively. One explanation given by Fama and French (1989),who analyze the connection between business cycle and stock returns,could be that companies experience difficulty in raising capital on the stock market. Along with that, the crisis in the bank sector further hampers financing because of the higher risk. Those two factors push companies to search for other forms of financing and they issue corporate bonds with higher yields in order to attract investors. Thus, while the stock market, driven by the ABX-HE index, loses in value, the corporate bond yields increase14. Therefore, from the stated, it can be summarized that the results are in line with the idea for contagion in the corporate bonds market also on the

and expected returns on bonds and stocks must be high to induce substitution from consumption to investment. When times are good and income is high, the market clears at lower levels of expected returns. 14 In order to clear the relation between 1TBY and ABX-HE indices it can be assumed that from the year 2008 onwards, each ABX-HE index has different relation with 1TBY. One way to measure it is to estimate only comovements between 1TBY and each ABX-HE index. For this purpose is performed a multiple linear regression, where 1TBY is dependent variable and the five ABX-HE indices are explanatory ones. The output is not presented (available upon request) but all betas are significant. From beta coefficients can be inferred the expected signs for VAR models where 1TBY is dependent variable. For ABX-HE-AAA and ABX-HE-BBBM indices the linear regression model predicts positive relation with 1TBY, while for ABX-HE-A, ABX-HE-AA and ABX-HE-BBB the relationship is negative. The degree of dependence is out of scope, so it is its discussion, but these results should be treated with scrutiny since short term market for government bonds is regulated by the US government and to a large extend depends on many factors, different from ABX-HE indices. 10TBY and S&P 500 continue to co-move in time. In line with Longstaff (2010) ABX-HE coefficients in regressions where dependent variable is 10TBY, remain positive for 2008. Therefore one should expect positive relation between 10TBY and S&P 500, and also between 10TBY and ABX-HE indices.

market for corporate bonds. Although the coefficients are lower than those estimated by Longstaff (2010), they are in line with his findings. Insert Tables 3 and 4 here Regression results for the ABX-HE-BBB index (Table 5) repeat those for ABX-HE-A. The loading of the ABX-HE variable -0.49 is significant at the 5% level only in Panel C, which again contradicts the contagion hypothesis . As for the ABX-HE-BBBM index (Table 6), none of its coefficients is significant. From the analysis above it can be concluded that there is evidence of contagion only forABX-HE-AAA index. Moreoverother CDO indices move in a different direction with the stock/bond markets. It is interesting that S&P 500 tracks the highest quality index and moves in different direction with the other indices. There might be a different story in the results if the sample is split year-by-year. Insert Tables 5and 6 here The results year-by-year for the weekly sample draw almost the same picture. In Tables 75 to 89, ABX-HE takes negative and significant loadings in Panel C. In 2008 (Table 81), the ABX-HE-AAA index has negative factor loading in Panel E -0.03 (5% level). The same is valid for the ABX-HE-BBBM index (Table 87) in Panels D and E for 2008 with coefficients 0.09 (10% level) and -0.07 (1% level). This result is in line with expectations for contagion in the corporate bond markets, as mentioned before. For 2009 the ABX-HE-AAA coefficient in Panel B is 0.09 (10% level), meaning that shocks in the index resulted in shocks in the fixed income markets for the sample period (Table 82), confirming theoretical explanations about expected values of explanatory variables in Panel B (see footnote 12). The year-by-year analysis confirms the significance of ABX-HE-AAA. Furthermore coefficients ofABX-HE-BBBM index are also significant which is not evident in the whole sample. In general results are unconvincing about a high degree of contagion going from the CDO to the stock and fixed income markets. On the contrary, many of the CDO index loadings are significant and negative/positive (S&P 500/corporate bonds), meaning that the markets and ABX-HE moved in different directions. Considering the positive correlation between all ABX-HE indices and S&P 500, ranging between 60% and 75% (see Table 1A), initial expectations are refuted. The other variables coefficients confirm preliminary theoretical analysis.

Longstaff (2010) uses weekly data in his analysis and results unambiguously show that there is contagion in the financial markets which goes from the CDO market to the rest. The current master thesis is based on a sample with later initial date 2007 2010 (compared to 2006 2007 in Longstaff (2010)) and that might be a reason for the inconclusive results. However,this outcome should be confirmed with more sensitive data, so the analysis is repeated on daily frequency basis. The next subsection discloses VAR model resultsr with daily data. It must be noted that for each regression is performed Lagrange-multiplier testfor autocorrelation and no autocorrelation is found in regressions. This holds both for regressions in which S&P 500 is representative for the market and for S&P Financials. Results US 2008-2010 S&P 500 daily Table 7 presents results from a sample with daily frequency for ABX-HE-A index. The sample comprises of 1319 observations, so there are multiple lags of the index. Akaike Information criteria are minimized for the first three, thirteenth and fourteenth lags of ABXHE index. Throughout the regressions ABX-HE coefficients are close to zero or

insignificant. In Panel C, where the dependent variable is S&P 500 index, the factor loadings of 10TBY are significant at the 10% level but are negative at -0.07. This contradicts the result and explanation in the previous section, despite that compared to the coefficients in Table 2 those are negligibly small. As forweekly sample, the pattern from Panel C appears in almost all regressions with daily frequency but withnegative sign. None of 1TBY coefficients is significant. Loadings of the different lags of the ABX-HE-A index are almost zero most of the time, which again restates that there is no contagion in the market. 10TBY is also significant in Panels D and E (same as weekly sample Table 2) with coefficients -0.22 (10% level) and -0.24 (5% level) for fourth lags, which is in line with Duffee (1998). Insert Tables 7 and 8 here In Table 8, Panel B the first three lags of the ABX-HE-AA index are significant at the 10% level with loadings of -0.01, 0.02, -0.01, and -0.01 (1% level), 0.02 (5% level) in Panel A. Although significant, those results are inconclusive for the degree of contagion since signs change from lag to lag. In Panel E, the first lag of ABX-HE-AA index is -0.01 (10% level) which is in line with Fama and French (1989) and the result in Table 4, meaning that there is contagion in the market for corporate bonds, but very weak. Output in Table 9 for the ABXHE-AAA index, is comparable to the one in Table 8. Coefficients (ranging between -0.01 and 0.02) in lag two of the index are significant at 1% and 5% level in all regressions except for

Panel C where zero. The coefficients signs are mixed, and result for ABX-HE-AAA misleading. Tables 10 and 11 show insignificant and close to zero loadings for ABX-HE-BBB and ABX-HE-BBBM , which restates results from first three indices. Insert Tables 9 to 11 here The analysis is split on a year-by-year basis and results are a bit different from those for the entire sample for all indices. In 2010, the ABX-HE coefficients, albeit very low, match expectations for contagion. In Panel C of Table 92 the third lag is 0.01 (10% level), and Panels D and E -0.07 (10% level) and -0.08 (5% level). None of the coefficients in Table 81 from the weekly sample (year-by-year) is significant compared to those. It appears that higher frequency data is more sensitive, since the influence of ABX-HE-A index is more pronounced. This is also valid for Table 93 where ABX-HE-AA loadings are positive and significant at the 5% level in Panels A and B (0.02) and also Panel E where it is at -0.01 (10% level). In Table 94, the Panel C coefficient is 0.01 (10% level). The result repeats for ABX-HE-AAA index in the same year with a factor loading of0.02 (1% level) in Panels A, B and E and 0.02 in 2009, but it is significant at 10% level in Panel A (Tables 96 and 97). In 2010 the fourteenth lag of ABX-HE-AAA takes values -0.03 (1% level) in Table 98 Panels D and E, however, the thirteenth lag is significant at the 1% level but with positive signs. Then again the coefficients for the second lag of ABX-HE-BBB in 2010 are significant at the 10% level in Panels C, D and E with factor loadings 0.01 (lag 3), -0.09 and -0.08 (Table 101). Their values for the third lag in Panels D and E are: 0.06 (10% level) and 0.06 (5% level). This inconclusive result might mean that the CDO indices are no longer reliable predictors of the market in the year 2010. None of the ABX-HE-BBBM coefficients is significant for the particular years except for 2010 (Table 104) where signs are different. Results show that there is a weak degree of contagion in the market; however it should be searched not in the whole sample, but year-by-year and only for the highest quality ABX-HE indices. Another finding is that there is no contagion in the year 2010, which might be caused by the different development of the crisis through the first years after it appeared and also by the US and European governments intervention on the market. From the weekly sample there is evidence for contagion only for ABX-HE-AAA , confirmed by the year-by-year regressions. The rest of the indices show inconclusive results, except for ABX-HE-BBBM, significant in the daily sample. Daily data confirms the results, but yearby-year analysis is a bit different from the rest. ABX-HE indices are most of the time

significant but with low coefficients. There is contagion but very weak and not for all the indices. For the years 2008 and 2009 evidence is more pronounced, but in much lower degree than initially expected. In 2010 coefficients signs are different, which leads to the conclusion that after the end of 2009 ABX-HE indices are no longer a reliable predictor of the market. It is reasonable to expect that CDO indices first contaminate the financial sector of the economy and it bears the greatest impact. Therefore, it might be that the degree of contagion fades with slower pace for financial institutions (represented by S&P Financials), than for the stock market (represented by S&P 500). That is why the analysis is repeated forUS using S&P Financials instead of S&P 500. Expectations are that results will show, higher degree of contagion compared to S&P 500. The next section presents weekly frequency regressions, followed by daily ones. Results US 2008-2010 S&P Financials weekly Table 12 presents the results for the entire sample period (ABX-HE-A index) in regressions where S&P Financials is used as a proxy for the financial sector. Surprisingly, coefficients of the CDO index are not significant. In contrast with initial expectations, none of the VAR coefficients is significant for all ABX-HE indices (Table 13 16) and even ABX-HE-AAA index has no predictive power compared to the S&P 500 sample. For the other regressions where dependent variables are 1TBY and 10TBY, the loadings of explanatory variables are the same as for the non-financial sample with small exceptions, so no further interpretation is necessary. Insert Tables 12 16 here Following the methodology used with S&P 500, regressions are repeated separately for each year. Year-by-year output is generally the same, however, for ABX-HE-A in 2009 the coefficient in Panel C is negative and significant at the 5% level-2.65 (Table 106), which contradicts the expectations for contagion. This result appears again in 2009 for ABX-HE-AA at -2.25 (10% level), ABX-HE-BBB at -2.40 (5% level) and ABX-HE-BBBM at-2.37 (Tables 109, 115 and 118). None of the other ABX-HE factor loadings is significant for the rest of the regressions, which is confusing since in the non-financial sample there is at least some evidence that ABX-HE-AAA co-moves with the market. It is already discussed in the previous subsection that the CDO indices are no longer a good predictor of the crisis in the year 2010. Coefficients in the financial sample regressions are

already insignificant in the year 2008. This means that, although financial crisis starts from banks and is transmitted to the rest of the economy, the financial sector was the first to be immune from from the movement of toxic assets. Weekly sample results are a bit different from daily ones in regressions where S&P 500 is used as a proxy for the stock market. In the next subsection models are repeated on a daily frequency basis to see whether there is some difference in output. Results US 2008-2010 S&P Financials daily Table 17 presents output for the entire sample period of ABX-HE-A index regressions with daily frequency. Almost all of the coefficients are close to zero and insignificant. In Table 18 the second lag of ABX-HE-AA is significant for all Panels except for Panel C with values ranging between - 0.02 (1% level) and 0.01 (10% level). The result is the same as for regressions where S&P 500 is a proxy and means that there is contagion in the market which comes from CDO indices. However, in Panel B for example, the loadings are inconclusive since lags 1 to 3 are with different signs. In the previous section it was mentioned that the ABX-HE coefficient in regressions where 1TBY is a dependent variable might be misleading. In Tables 19 and 21 the second lag is positive and significant at the 1% level in all panels with factor loadings 0.01 except for the third one. However, different lags are with multidirectional signs, which is contradictory and again confirms the analysis in the

previous section where the majority of indices have insignificant coefficients. Only ABX-HEAA shows a very weak degree for contagion, but there might be difference in regressions performed year-by-year. Insert Tables 17 21 here Few of the coefficients are significant and with distinct signs in year-by-year output (Tables 120 to 134). Analysis is again contradictory for the degree of contagion. In general, evidence for contagion in the US is mixed. Only ABX-HE-AAA is significant in regressions with S&P 500 as the dependent variable and also for corporate and Treasury bond yields in the weekly sample. The evidence for the rest of the ABX-HE indices is ambiguous in the weekly sample. Year-by-year analysis confirms this except that ABX-HE-BBBM is also supported. Regressions for the whole sample with more sensitive data are not different. However, the analysis year-by-year analysis based on the daily sample, ABX-HE-A and ABX-HE-AA indices show, albeit weak, significant results for the years 2009 and 2010 in all Panels except for C. ABX-HE-BBB and ABX-HE-BBBM have no predictive power in the daily sample. In

the regressions where S&P Financials is used as a proxy for the financial sector, none of ABX-HE indices has predictive power through the years 2008 to 2010. In the daily sample only ABX-HE-AA is in line with contagion expectations. Error terms in the weekly regressions are statistically significant and with very high values, ranging between 22.7 and 118.20. In the weekly financial sample, only error terms in Panel C are significant, whereas in daily regressions few of the error terms are significant and with values around 0.05, which holds for both financial and non-financial sectors. In this case the large standard errors, where at place, mean that weekly sample regressions do not explain much of the variance, which is also evident from the analysis presented above. R square15 varies significantly in panels but in general keeps the following pattern: in Panels A and B it is around 20%, in Panel C is around 25% and in Panels D and E it isup to 98%. In the year-by-year analysis for Panels A, B and C, R squares are around 56%. In the financial sample for all Panels except for C, R squares is around 95%, and in Panel C around 20%. R squares ranging around 20% are comparable to those obtained by Longstaff (2010) for the year 2006, where regressions have no predictive power. R squares ranging around 95% are not due to the high explanatory power of ABX-HE indices, since almost none of their coefficients is significant. Therefore results restate those from Longstaff (2010). P values of all regressions are close to zero, except for the Panel B which confirms its low predictability. There is one pattern for P values for the whole regressions. In panel B, where 1TBY is the dependent variable and the P value for the whole regression is more than 0.16 for all indices. High P values appear also in the financial sample in the year 2008 but in Panel C. For all other panels in the two samples, the P value is less than 0.04. Thus 1TBY regressions have no predictive power. Da obqsnqtestovetekoitosapravenI I posle da gIdobavq sled vsekI model nakraq v generalnoto zakliu4enie Explain the following: 1. R2 2. F-stat 3. P values 4. RMSE
15

Under each panel are presented adjusted R, F-statistics, P values and RMSE for the regression and. Under Panel E are presented information criteria as follows: Log Likelihood, Akaike information, Bayesian information, Hannan-Quinn, and number of observations.

The RMSE is the square root of the variance of the residuals. It indicates the absolute fit of the model to the datahow close the observed data points are to the models predicted values. Whereas R-squared is a relative measure of fit, RMSE is an absolute measure of fit. As the square root of a variance, RMSE can be interpreted as the standard deviation of the unexplained variance, and has the useful property of being in the same units as the response variable. Lower values of RMSE indicate better fit. RMSE is a good measure of how accurately the model predicts the response, and is the most important criterion for fit if the main purpose of the model is prediction. The best measure of model fit depends on the researchers objectives, and more than one are often useful. The statistics discussed above are applicable to regression models that use OLS estimation. Many types of regression models, however, such as mixed models, generalized linear models, and event history models, use maximum likelihood estimation. These statistics are not available for such models.

5. 6. 7. 8. 9.

Akaike information Bayesian information Hannan-Quinn, and number of observations. Shwarz criterion SBIC

Da se namerqtot PDF stoinostite I otnovo da se popravqt Log Likelihood function16 ranges between -560 (year-by-year) and -2450 for whole sample weekly regressions, and -2180 to -6436 for the same period but with daily frequency. In the financial sample the numbers are between -460 and -2292 in corresponding weekly regressions, and -2380 to -5900 in corresponding daily sample. Akaike information in all regressions takes values 35 to 37 in weekly regressions and -16 to 24 in sample with daily frequency. In the corresponding financial samples with weekly/daily frequency values range from 30 to 35 and -14 to -16 for daily.

1. 2. Hannan-Quinn, and number of observations. 3. Shwarz criterion= SBIC is in the daily S&P 500 sample-16 to -20, around 40 for weekly and -12 to to -20 for S&P Financials daily and 36 for weekly In the Data section it is mentioned that the analysis extends beyond the US market compared to Longstaff (2010). In 2007 it came out that European banks held substantial amount of risky US securities. On the other hand, Beltran et al. (2008) estimate that foreign exposure to US loans is around 22% (of which only small amount belongs to Europe), but they use different methodology for estimation. Local CDO indices (iTRAXX) us used for the analysis of ABX-HEFor the analysis is used local CDO index iTRAXX, but not ABX-HE. The direct
16

Log Likelihood function returns the most likely values of the parameters from which is estimated the actual data, and is estimated by the software through iterations. It can be used both in linear and non-linear models, so is reliable for VAR and Probit models

connection between US and European CDO markets is not examined, which is one limitation of this master thesis. The presumption is that European investors expectations, driven by the crisis in US, contaminate the European market for securitized loans and then trigger a wave to rest of the market. Results from the US are not convincing,expectations are that in Europe contagion is more pronounced at least till the end of 2008 since the crisis was transformed at a later stage.

Europe
Results US 2006-2010 S&P Europe weekly Before starting the analysis, it has to be noted that the interpretation of coefficients for Europe will be different compared to that for the US. Since the index presents the premium paid on CDS in Europe, the higher the risk for those CDS, the higher the premium will be, compared to ABX-HE where the indices were falling as risk increases (seeData section for further explanation). Table 22 shows the results from the sample with weekly frequency for Europe. In Panel C the coefficient of the iTRAXX index is 0.18 (1% level). If there is contagion in the market the sign should be negative. There is no evidence that the CDO index causes any influence on the long and short-term Treasury bond yields in Europe, where coefficients are close to zero. Tables 135 139 present the regressions for Europe year-byyear from 2006 to 2010 and confirm the above mentioned. Results for the whole sample in Europe are no different than those in the US CDO market and even year-by-year output is not significant. For each regression in the daily sample a is performed Lagrange-multiplier test for autocorrelation is performed and no autocorrelation is found, both for regressions in which S&P Europe is representative for the market and for MSCI Europe Financials. Insert Table 22 here Results US 2006-2010 S&P Europe daily Since there are more observations, there are also more lags of the iTRAXX index in the daily sample. Akaike Information criteria are minimized for the first four lags of ITRAXX. Table 23 (results from daily frequency whole sample) confirm the models outcomes for Europe. In Panel C the third and fourth lags are significant at the 1% and 10% level with coefficients 0.05 and 0.03.

In Panel B, the third lag loading is 0.07 (10% level) (this result should be treated with scrutiny)17. Tables 140 144 present year-by-year VAR output for Europe. Going through 2006 to 2010 there is no evidence for influence of the index on the stock market. Not surprisingly, in the year 2006 the coefficient of the fourth lag of the iTRAXX index 0.10 is significant at the 5% level which means no contagion at that time. None of the coefficients for the bond market is significant meaning that there is no evidence for contagion. In the year 2008 (Table 142) the third lag of the iTRAXX index is significant in all panels, with factor loadings of 0.12 (10% level), 0.21 (5% level) and 0.10 (5% level). In 2009 coefficient of the fourth lag of iTRAXX is 0.10 (5% level) in Panel C. Then again in 2010 the loading is 0.11 (significant at 5% level) for the first lag of the iTRAXX index and also 0.25 (5% level) in Panel A (Tables 143 and 144). Therefore in Europe there is no evidence of contagion in the market. Probably the portfolio of iTRAXX does not contain as many toxic assets as ABX-HE and European banks are contaminated through their large expositions in US CDOs. The following analysis will check the predictability power of iTRAXX in a sample which comprises only from financial companies in Europe. Insert Table 23 here Results Europe 2006-2010 MSCI Financials Europe weekly Table 24 presents results for MSCI Europe with weekly frequency. For the 2006 2010 sample period the coefficients of iTRAXX index are negative and significant the at1% level in Panels A and B with values -0.03 and -0.02, which is in line with initial expectations for contagion, although the degree is very low. For the years 2006 to 2010 from the year-by-year analysis (Tables 145 to 149) the CDO index is the same, with the same significance. There is no evidence of contagion in the weekly sample for MSCI Financials except only for the market of government bonds. The next section considers the daily sample results. Insert Table 24 here Results Europe 2006-2010 MSCI Financials Europe daily Table 25 depicts the results for MSCI Europe Financials. Akaike Information criteria are minimized for the first four lags of iTRAXX. In Panels B and C the third lag of the indices are
17

Each ABX-HE index has different relation with 1TBY, so the influence of iTRAXX on the European short term Treasury bond market is also estimated with linear regression (output available upon request). The expected sign is inferred from beta coefficient for the model where 1TBY is dependent variable. In contrast to US, in Europe the beta coefficient is zero to the third sign. If 1TBY and iTRAXX are plotted in one graph they move in different directions only in 2006, but afterwards the graph is almost flat and the regression confirms that.

0.07 (1% level/10% level), which is in line with the weekly sample and the year-by-year analysis since in Panel A the loading is -0.06 (10% level). This evidence is again misleading because of the different coefficient signs . Year-by-year regressions depict the same. In 2007 (Table 151) the first lag of the index is 0.07 (1% level) in Panel C, and 0.11 and 0.13 (5% level) in Panels A and B, but the fourth lag has a value of -0.06 (1% level) in Panel C. In 2008 (Table 152) the third lag is significant at the 5% level in Panels B and C with coefficients 0.12 and 0.21. In 2009 none of the loadings is significant, but in2010 the first lag is 0.15 (1% level) in Panel C, the second, third and fourth lags in the Panel A are significant at the 10% level with factor loadings 0.21, 0.24 and 0.21 (Table 154). Insert Table 25 here R square in the weekly and daily sample is very high in Panels A and B (95%), but close to 0 in Panel C. The same pattern can be seen in the year-by-year analysis except that in Panel C values range between 11 and 20%. This is valid for financials and the whole sample regressions. P values of the whole regressions are zero to the third sign, except for Panel C where probabilities are higher than 0.10.

Log Likelihood function ranges between -540 in 2006 (year-by-year weekly regressions) and 650 in 2008. In the financial sample values are -435.33 in 2006 to -622.24 in 2008. For whole sample weekly regressions is between -3187.78 and -2951.64 in the financial ones. In daily output Log Likelihood function takes values 8574.53 and 8407.09 in the financial sample.

Akaike information and Shwarz criteria are 24.61 and 24.94 in weekly whole sample regressions, corresponding to 22.80 and 23.13 in the financial sample. In the year-by-year analysis AIC and SBIC are 23.02 and 23.95 in 2006 compared to 25.96 and 26.86 in 2008. The corresponding values in financial sample are 18.75 and 19.67 in 2006 (24.86 and 25.76 in 2008). In daily sample AIC and SBIC are -12.96 and -12.76 whereas in financial sample they are -12.71 and -12.51. And in the year-by-year analysis values are -16.54 and -15.84 for 2006 compared to -12.67 and -11.97 in 2008. In financial sample for 2006 AIC is -16.71 and SBIC is -16.01, but for 2008 corresponding values are -10.91 and -10.22. The results for financial sample are ambiguous. In the version with weekly frequency, there is evidence for contagion only for government bonds and none about MSCI Europe Financials. The daily version is even more misleading since the different lags are with different signs. Compared to the US, in Europe the model shows less significant coefficients. Results are

significant only in the whole sample period and none of the coefficients in year-by-year analysis brings any evidence for contagion but just on the contrary.The same is valid for the S&P Europe regressions. In the next section Probit 1 and 2 models for US and Europe are presented in the same sequence as VAR, starting with the weekly US sample

4.2 Probit model results US

The results from Probit models both for the US and Europe are presented in Tables 155 to 202 in the Appendix. However, parameters cannot be directly interpreted from the output because the form of the function is nonlinear. Additional calculations are needed to estimate the marginal effects at the mean of the independent variables. The tables below present values in percentages, which can be interpreted as linear regressions. Primary output from Probit models is presented in the Appendix,from which significant coefficients are inferred. Probit 1 US Weekly Table 26 presents Probit 1 probabilities for ABX-HE-A index. Explanatory variables loadings are significant at the 10% level for the first and 5% level for the second lag, but with different signs: 0.58% and -1.07%. It would mean that initially a 1% increase/decrease of the CDO index would increase the probability that S&P 500 (the dependent variable) will have positive/negative return with 0.58%. Two weeks afterwards the trend changes and a1% increase/decrease in ABX-HE-A would mean decrease of the probability for positive impact on the S&P 500 by 1.07%. Therefore, explanatory variables no clear conclusion can be made and the percentages are very low. Insert Table 26 here Most of the coefficients in Panel C are significant at the 10% level except for AAA Corporate Bond yield. They are also in line with theoretical explanation presented in the VAR models section. The first lags of 10 and 1TBY and BAA Corporate bond yield have probabilities of respectively 1.10%, -61.87% and -79.55% (all significant at 10% level). As already mentioned, this result is reasonable since there is negative relation between 1TBY and S&P 500 and positive between S&P 500 and 10TBY. Also, in line with Fama and French (1989), there is negative relation between corporate bond yield and stock market returns. To interpret the results in terms of Probit model for every percent increase/decrease in BAA Corporate or 1TBY, the probability that S&P 500 will rise/fall (in terms percentage return)decreases with

62% for BAA Corporate bond yield and 80% for 1TBY. However the estimated percentage of 10TBY very low. In Panel A the first lags of the BAA and S&P 500 variables are significant at the 1% and 5% level with probabilities -99.91% and -67.58%. This would imply that a 1%increase/decrease in BAA or S&P 500 will decrease the probability that the 10TBY (the dependent variable) will have positive/negative return with 99.91% and 66.58%.In Panel B the first lags of S&P 500 and 10TBY are significant at 1% and 5% level with probabilities -97.47% and 2.53%. In Panel D where AAA Corporate Bond yield is the dependent variable, none of the coefficients is significant. Panel E presents a regression where BAA Corporate bond yield is dependent variable. The first lags of S&P 500 and AAA Corporate Bond yield are significant at the 5% and 1% level with values -4.46%, 95.51% and -4.46% (for the second lag of AAA Corporate Bond yield). This would mean that probability of increase in BAA Corporate bond yield would drop by 4.46% if there is a percentage increase in the S&P Europe index. Interesting here is that the factor loadings of the first two lags of AAA Corporate Bond yield are significant but with negative signs. A drawback from that would be that initially percentage increase in the AAA Corporate Bond yield leads to surge of BAA Corporate bond yield with a 95.51% probability. And after two weeks this probability is negative but with a very low impact. In none of the Panels, except for the third one, the ABX-HE-A index is significant; then again no clear conclusion can be made. In Table 27 are presented probabilities for ABXHE-AA index. In Panel A the same coefficients are significant as in Table 26 S&P 500, 1% level, BAA Corporate bond yield, 5% and 10% level (columns (1), (7) and (8)). The factor loadings in Panels B, C, D and E in Table 27 almost perfectly coincide with those from Table 26 with the same significance level of the lags and percentage values different only either in the sign after the decimal or at most 2%. In Table 28 the ABX-HE-AAA index coefficients are comparable to those in Tables 26 and 27. Loadings of ABX-HE-AAA are significant in Panel A at 10% level with probabilities 0.02% and -0.03%. However, those values are very low and moreover with different signs. For the other Panels in Tables 28 and 29, the variables behave in the same way with similar probabilities and significance as in Tables 26 and 27. Panel C of Table 30 presents a regression where S&P 500 is the dependent variable. Factor loadings of 10TBY, BAA Corporate bond yield, 1TBY and the ABX-HE-BBBM index are significant at the 10% and 1% level. Results are not conclusive since signs are different for subsequent lags. Insert Table 27 to 30 here

In general, for the weekly sample, it can be concluded that ABX-HE index has no influence on the dependent variables, compared to the other independent variables and most of the time the coefficients are insignificant. Also there is one, somehow misleading pattern of behavior of the index in the different regressions, which can be seen in all the tables. In Panel A the index changes the probability from positive to negative (from the first to the second lag). This rule also holds in Panels C. Daily The daily sample contains more observations and, therefore, more lags are included. Table 31 presents probabilities for ABX-HE-A index. In the second regression (Panel B) the fourteenth lag of ABX-HE-A and the second lag of S&P 500 are significant at the 10% level with probabilities -2.79% and -31.96%. This result is different from the sample with weekly frequency (Table 26), where the CDO index coefficients are insignificant. It means that one percent increase in the index decreases the probability of percentage increase of 1TBY with 2.79%. The same holds for the relation S&P 500 1TBY, but with the significantly higher probability of -31.96%. Panels D and E are comparable to those from the weekly sample for the same index. Insert Table 31 here In Table 32 the effect of ABX-HE-AA is more pronounced than in Table 31. In Panels A, B and D the first and fourteenth lags of the index are significant. In the first, second and fourth regressions, the fourteenth lag is significant at the 5% level with probabilities -1.08%, -1.64% and -1.02%. This is valid for first lags in regressions, but significant at 10% level and higher values. The result in Panel D is in line with the idea for contagion in the market, which comes from ABX-HE indices and goes to corporate bonds. Table 33 depicts the results for ABX-HE-AAA and reasserts those for ABX-HE-AA. Going ahead with Tables 34 and 35, where ABX-HE-BBB and ABX-HE-BBBM are independent variables, one can see that none of the indexs coefficients is significant. Only S&P 500 and 1TBY independent variables are significant in most of the regressions. From the weekly and daily samples of Probit 1, there is no evidence for contagion in the market. In the VAR section, models are examined with daily and weekly frequency, but with different indices, representative for the stock market.The next section examines the relation between ABX-HE and the financial sector of the economy only, represented by the S&P Financials index. Insert Tables32 35 here

Probit 1 US Financial sample Weekly In Table 36 the ABX-HE-A coefficient is not significant, but the first lags of 10TBY, 1TBY and BAA Corporate bond yield are significant at the 5% and 10% level with probabilities 1.10%, -33.93%, -61.87% and -79.55. These results are very close to the probabilities from S&P 500 (Table 26), so no further explanation of output is necessary. The other three regressions have comparable probabilities as in Table 26, except for ABX-HE-A which is insignificant. In Table 37 the first lag of ABX-HE-AA index is significant at the 5% level in Panel C with probability 0.10%. This is the first evidence for co-movement of the S&P Financials index and ABX-HE index, but loading is negligibly small. The other independent variables have comparable percentage loadings as in Tables 36 and 27. Insert Table 36 and 37 here In Table 38 the first lag of ABX-HE-AAA index is significant in Panel C together with 10TBY at 1% level with percentage values -0.11% and 16.21%. But then the influence of the CDO index on S&P Financials reverts, as the sign changes in the second lag, which is misleading. In Panels D and E from the same table two lags of ABX-HE-AAA are

significant again at the 5% and 1% level with factor loadings of -0.02% (lag 1), -0.23% (lag 2) and -1.06% (lag 1), -1.65% (lag 2). This is evidence for contagion in the market, but percentages are very low. Tables 39 and 40 present regressions where ABX-HE-BBB and ABX-HE-BBBM indices are independent variables. Except for lags 1 and 2 of ABX-HEBBBM index in Panel B which are significant at the 10% level with probabilities of -12.17% and 8.64% (again contradictory), none of the other coefficients is significant. The other independent variables are comparable to the regressions with the ABX-HE-A, ABX-HE-AA and ABX-HE-AAA indices. Insert Tables38 40 here Results from the financial sample are comparable with those from the S&P 500 index regressions. A difference here is that ABX-HE-AAA and ABX-HE-AA indices coefficients show negligible degree of contagion in the stock and bond markets. The same pattern appears in Panels A, B and C in all tables - the probability changes from positive to negative from the first to the second lag (exception is ABX-HE-BBBM index). Follows Probit 1 model probabilities for the financial sector, estimated from the sample with daily frequency.

Daily Table 41 presents the ABX-HE-A index from the daily frequency samplesample with daily frequency. Probabilities are comparable to those from the weekly sample except that in Panel B the index is significant at the 10% level with impact probability of -2.84%. In Table 42, Panels A, B and D all of the regressions (except for the third one) have significant probabilities for the different lags. In Panel A the fourteenth lag is -1.05% (5% level) and Panel B -1.76% (1% level). In Panel D the three lags are significant at the 1% level with values -4.47%, 0.76%, -1.04%. Results contradict the idea for contagion, except for Panel D where the relation between CDO and ABX-HE indices is negative. Table 43 reasserts the result from Table 42 except that ABX-HE coefficient in Panel E is also significant with impact of probability -1%. ABX-HE-AAA has most significant influence on the dependent variables, compared to the other indices. As for Tables 44 and 45 there is no evidence for relation between ABX-HE and the stock or bond markets. The other independent variables have comparable percentage loadings as in the weekly sample. The daily frequency regressionsRegressions with daily frequency confirm the results from weekly sample. Insert Table 41 45 here Probit 2 US Weekly The second major Probit 2 which examines the direction of co-movement of the variables is examined in this section. The model takes into account only past positive and negative movements in the CDO indices (but not their values) and their influence on the stock and bond markets. In Table 47 only the first lag of ABX-HE-A is significant at the 10% level for the Panel C with probability -1.13% or for every positive return of the CDO index the probability for positive return in S&P 500 decreases with 1.13%. This counters the idea of contagion in the market. In Table 48 where ABX-HE-AA is explanatory variable, none of the coefficients is significant. In Table 49 (ABX-HE-AAA, Panels C, D and E the factor loadings are significant at the 1%, 5% and 1% levels with probabilities 0.39%, -17.67% and -2.17%. The probabilities are low but still they are in line with the idea of contagion. In Tables 50 and 51 where ABX-HE-BBB and ABX-HE-BBBM indices are explanatory, none of the coefficients is significant except for the second lag of ABX-HE-BBBM in Panel B of Table 51 with probability -16.69% (1% level). Probit 2 confirms the results from Probit 1 (weekly

and daily sample),where only ABX-HE-AAA has influence on the bond markets. The last two indices have no influence. Insert Tables47 51 here Daily None of the ABX-HE-A coefficients in Table 52 is significant in daily sample. The other independent variables which are significant have approximately the same probabilities as in Table 42. In Table 53 ABX-HE-AA, index is significant at 5% level in Panels B and D with probabilities 9.13% (lag 7) and -7.15% (lag 2). In Table 54, Panels A, C, D and E the index coefficients are significant at the 5% and 10% level. In Panels A and C the second lag is significant at the 10% level with probabilities 4.46% and -4.32%. In Panels D and E

probabilities are significant at the 10% level with loadings -6.38% and -3.24%. Coefficients in Panels A, D and E show degree of contagion in the market, albeit percentage changes of probabilities are very low. This means that for every positive/negative movement in the return of the CDO index, the probability for positive/negative return in 10TBY increases by 4.46%. The same holds for AAA and BAA corporate bond yields where the probability decreases with 6% and 3%respectively. Coefficients of ABX-HE-BBB and ABX-HE-

BBBM are characterized by reverting behavior meaning that in the first lags they are positive and for the second or third, negative, therefore no clear conclusion can be made about them. Insert Tables52 56 here In general, the results from the weekly and daily sample, show negligibly low degree of contagion for stock and corporate bonds markets with very low probabilities. The only indices which are significant are ABX-HE-AA and ABX-HE-AAA. The other independent variables have the same values in all tables, which can be seen also in Probit 1. Probit models with daily and weekly frequency were presented in the previous section, In the previous section were presented Probit models with daily and weekly frequency, but with different indices, representative for the stock market. Next section examines the relation between ABX-HE indices and the financial sector of the economy only, represented by S&P Financials . Compared to the first Probit, here the model takes into account only past positive and negative movements in the CDO indices but not their percentage returns.

Probit 2 US Financial sample Weekly Tables 57 and 58 present probabilities where ABX-HE-A and ABX-HE-AA are dependent variables. None of the regression coefficients is significant except for Panel C at 1.1%. In Table 59 ABX-HE-AAA index is significant for the last three regressions (Panels C, D and E) at the 1% level with probabilities 0.39%, -17.94% and -2.70%. This result is in line with expectations for contagion in the stock and bond markets and again reasserts that markets are most sensitive to ABX-HE-AAA . In Tables 60 and 61 none of the ABX-HE-BBB and ABXHE-BBBM coefficients is significant, which is not surprising since those two indices have low predictability power in the other regressions. Finallyq the daily sample where S&P Financials index is used as a proxy for the US stock market is analyzedFinally for US is analyzed the daily sample where S&P Financials index is used as a proxy for the stock market. Insert Tables 57 61 here Daily In general, results from sample with daily frequency repeat those from the weekly sample. ABX-HE-A coefficients in Table 62 are not significant with small exceptions. In Table 63 ABX-HE-AA is significant at the 1% level in Panel B (probability 10.35%) and in Panel D (7.29%), which is in line with the notion for contagion in the markets that goes from ABX-HE index to the market for government bonds. In Table 64 ABX-HE-AAA coefficients in Panels A and C are significant at the 10% level with probabilities 3.72% and -4.32%. Here again the first result confirms the expectations for contagion, but in the second regression, where dependent variable is S&P Financials index, the probability is negative which contradicts evidence for contagion in the stock market. Then in Panels D and E probabilities are -6.37% and -4.06% for the AAA and BAA Corporate bond yields. Not surprisingly ABX-HE-BBB and ABX-HE-BBBM index coefficients have no predictive power. The other independent variables have probabilities comparable to those in Table 62. Insert Tables62 64 here Concluding from Probit 1 (weekly and daily samples) the evidence for contagion is scarce. In the weekly sample regressions, CDO coefficients have positive values in the first lags and negative afterwards. The effect of ABX-HE is most pronounced for indices with rating AA

and AAA, and in Panels D and E where dependent variables are AAA and BAA Corporate bond yields. In those panels, probabilities are quite low. ABX-HE-BBB and ABX-HE-BBBM are insignificant in almost all regression (including financial sample). However, there, ABXHE coefficients are significant also in Panel C (only for highest ratings indices). In general, ABX-HE-A brings most misleading evidence since its coefficients change in signs through all regressions, whereas indices with lowest ratings are insignificant. The above analysis also holds for Probit 2 model (both for daily and weekly samples), where only the positive/negative movement between variables is observed. The main difference with Probit 1 is that for the second model percentage probabilities are a bit higher, so the degree of contagion is somehow more pronounced. drawback from the two models is that contagion (or alternatively no contagion) is equally pronounced in regressions where S&P 500 is dependent variables and also for S&P Financials. Therefore there is no clear distinction between the financial sector and the rest of the economy. The next section is dedicated to Europe and examines the probability of contagion in the stock and fixed income markets by the European CDO market represented by iTRAXX index. First Probit 1 and 2 using S&P Europe are analyzed in order to measure the degree of contagion in the stock market, followed by the results for the financial sector represented by MSCI Financials Europe. Probit 1 indicates that the probability of observing positive or negative movements in the markets depends on the previous movements in the same markets and the size of the credit factors, whereas Probit 2 takes into account previous movements plus the direction of the credit factors. As already noted , tables do not represent primary output from regressions, but only marginal effects at the mean of the independent variables. Primary output is presented in Tables 154 to 202 in the Appendix, from which significant coefficients are inferred. Also the interpretation of iTRAXX coefficients differs from ABX-HE ones, since the first index presents the premium paid on CDS. Therefore, if there is some degree of co-movement (contagion) in the market, one should expect negative coefficients in the S&P Europe and 10TBY regressions (positive in 1TBY regressions). Probit 1 Europe Weekly Table 67 presents probabilities for Europe from the sample with weekly frequency. None of the iTRAXX coefficients in the regressions is significant. The only significant variables in Panel A are the first lags of the S&P Europe index and 1TBY, significant at the 5% and 10%

level with values of 51.54% and -41.47%. However, the second lag of 1TBY has probability of 43.19% significant at the 10% level which is the opposite of the first lag. Therefore, the only the positive relation between long-term government bond yield and S&P Europe is confirmed and there is no evidence for contagion in the market, which is valid also for Table 68 where analysis is done on a daily basis. Only in Panel B iTRAXX is significant at the 5% level with change in probability -65.42% and -68.30% for the first and third lags, which contradicts the idea for contagion in the market. Results in Tables 69 and 70 (weekly and daily sample of Probit 1 Financial sample), where dependent variable representative for market is MSCI Europe Financials, are comparable to those in 67 none of the factor loadings is significant. Insert Tables67 74 here In Table 71 (Probit 2 weekly sample) the first lag of iTRAXX in Panel C is significant at the 1% level with assigned probability of 2.02%, which contradicts with the expectations for contagion. None of the other coefficients is significant. Output from the daily frequency samplesample with daily frequency in Table 72 depicts the same, which holds also for Tables 73 and 74 Europe Financial samples where Probit 2 regressions are placed.

Conclusion
VAR US The results from the US for VAR model show that there is contagion in the market, but it is pronounced mainly in regressions where ABX-HE-AAA is an exogenous variable. The influence of the index is pronounced both in corporate and government bond markets and also on the stock market. For the other indices coefficients are not unambiguous. The weekly sample ABX-HE-A index show negative loading in Panel C (where S&P 500 is dependent variable). The other ABX-HE indices (ABX-HE-BBB and ABX-HE-BBBM) show negligible evidence for contagion, but only in Panels D and E (AAA and BAA Corporate bond yields). Those are pronounced mainly in the year-by-year analysis and in the daily sample. Actually, in daily sample most of the indices show weak degree of market co- movementco-movement with markets. During the years 2008 and 2009 evidence is more pronounced, but in much lower degree than initially expected. For 2010 coefficients signs change from lag to lag, so the results are misleading. These results lead to the conclusion that after 2009 ABX-HE indices are no longer reliable predictor/contaminator of the market. The regressions where

S&P Financials is representative of the market, differs from the S&P 500 ones. ABX-HE is significant almost nowhere. Where significant, the signs differ from lag to lag. So, in the financial sample, regressions are already insignificant in the year 200818. It appears that long-term Treasury bonds are a good predictor of the stock market represented by S&P 500 . For each ABX-HE index, in the S&P 500 regression (Panel C) the first lags of 10TBY are significant at least at the 10% level, with coefficients around 0.74. The same is valid for 1TBY, where the first two lags are significant but with negative signs. Also, in accordance with Duffee (1998), there is a negative relation between long-term Treasury bonds yields and AAA and BAA Corporate bond yields (the degree of co-movement differs for bonds with AAA and BAA ratings). Probit US From Probit 1 (weekly and daily samples) the evidence for contagion is scarce. In weekly sample regressions, the iTRAXX coefficients take positive values in the first lags and negative afterwards. The effect of ABX-HE is pronounced for indices with ratings AA and AAA and in Panels D and E, where dependent variables are AAA Corporate bond yield and BAA Corporate bond yield, but this effect is negligibly small. ABX-HE-BBB and ABX-HEBBBM are most of the time insignificant. In general regressions from the financial sample confirm the ones from whole sample. However, there, ABX-HE coefficients are significant also in Panel C (only for indices with highest ratings). ABX-HE-A brings most misleading evidence since its coefficients change in signs through all regressions, whereas indices with the lowest ratings are insignificant. The above analysis is valid also for the Probit 2 model (both for daily and weekly samples). Compared to Probit 1, in Probit 2, percentage probabilities are a 1 to 4 percent higher. Contagion (or alternatively no contagion) is equally pronounced in S&P 500 and also in S&P Financials. Therefore, there is no clear distinction between the financial sector and the rest of the economy. Final conclusion from the two models for the US is that there is very weak evidence for contagion only for ABX-HE-AAA index. The results from the other indices (where significant) neither refute nor confirm contagion in the US markets.
18

Also from linear regression analysis is obvious that after 2007 each CDO index has different influence on 1TBY, and cannot be expected coefficients with the same sign for all indices. With a few exceptions, the signs of VAR output coefficients almost perfectly coincide with those from the betas of OLS regression. The signs are also in line with those from the last year of Longstaff (2010) papers sample. Therefore one year Treasury bond yield moves influenced by ABX-HE indices, or otherwise they contaminate the market. Of course this result must be treated with conscious since short term Treasury bond yield is regulated by the government and many different factors can influence it.

Europe VAR Europe The weekly analysis for Europe does not show contagion in the stock and bond markets, which goes from European CDO market, represented by iTRAXX . This is valid both for whole sample regressions and year-by-year analysis daily and weekly frequency. One reason for these results might be that contagion in Europe is brought by the large exposure of European banks to US portfolios which contain many toxic assets as some of ABX-HE. In the regressions where MSCI Europe Financials is representative for the stock market, the coefficients in Panels A and B show low degree of contagion for the long and short-term Treasury bond yields, but no evidence for the financial sector. However the this is not confirmed from the sample with weekly frequency since there coefficients change from lag to lag. None of the Probit models modifications for Europe show any degree of contagion. Possible further research There is one possible extension of this master thesis. The focus is US and European markets separately or otherwise ;the connection between US ABX-HE indices and European market for CDOs (iTRAXX) is not regarded. It would be interesting to test how (or whether at all) European stock and bond markets co-move with ABX-HE indices. Moreover, this relation should be scrutinized from the very beginning of 2006. conclusions which upwards , extend them a bit and also relate them to Lonstaff!!!! Da ne zabravq da napravqtablicizakorelacia DA NE ZABRAVQ CVETNITE TABLICI zaprezentaciq Da obarnavnimaniena R^2 za6to satolkovagolemI I trqbvalI da e takaprItoq vid regresii Da opravqnavsqkade Hypothesis Da popravq BBM za6toto e ABX-HE-BBBM s 3B Da komentiram testovete v kraq na vsqka subsection vsi4kI koeficienti

Treasury bond yields from corporate bond yields in order to compute the spread or directly used Corporate bond yields? Corporate bond yield tell Post that I use them directly but not the spreads (explain also how the author handles them.

Da komentiramtestoveteI zaProbititeI zaVARovete Da smenq exogenous I endogenous

http://www.medcalc.org/manual/f-table.php INFLUENCE=CONTAGION Survey=writing if I have to refer to the Master thesis

Liquidity and risk premium channels or correlated channel? ABX-HE main article. Article - ABX-HE how the market prices folder 21Jan from page 6 onwards, there is explanation for results. Some of the variables WEeuse are explained too. .

http://dss.princeton.edu/online_help/analysis/interpreting_regression.htm

/this is for t-stat */ Since the results for weekly data both for US and EU are corrected for small sampleI use confidence levels for significance from the P-values of the output. Where necessary for more precise estimation I use linear interpolation between the closest values. http://www.dailymarkets.com/stock/2009/05/24/bond-yield-curve-and-the-stock-market/ Da napravq vsi4ko vav sega6no prostovreme WEe=I most of the time Financial Sector - change Table of figures Table of contents