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How Does the Market Value Toxic Assets?

Published online by Cambridge University Press:  23 April 2014

Francis A. Longstaff  and
Brett W. Myers
Francis A. Longstaff
Affiliation:
[email protected], Anderson School of Management, 110 Westwood Plz, University of California at Los Angeles, Box 951481, Los Angeles, CA 90095
Brett W. Myers
Affiliation:
[email protected], Rawls College of Business, Texas Tech University, Box 42101, Lubbock, TX 79409.
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Abstract

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How does the market value “toxic” structured-credit securities? We study the valuation of what is possibly the most toxic of all toxic assets: the equity tranche of a collateralized debt obligation (CDO). In theory, CDO equity should be similar in nature to bank stock since both represent residual claims on a portfolio of loans. We find CDO equity returns are much more related to stock returns than to fixed-income returns. CDO equity returns track the returns of financial stocks much more closely than any other industry. Nearly two-thirds of the variation in CDO returns can be explained by fundamentals.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 49 , Issue 2 , April 2014 , pp. 297 - 319
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2014 

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