How Does the Market Value Toxic Assets?

Francis A. Longstaff and Brett W. Myers

Journal of Financial and Quantitative Analysis, 2014, vol. 49, issue 2, 297-319

Abstract: 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.

Date: 2014
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