Abstract
This study aims to investigate the existence of contagion between liquid and illiquid assets in the credit default swap (CDS) market around the recent financial crisis. The authors perform analyses based on vector autoregression model and the dynamic conditional correlation model. The estimation of vector autoregression models reveals that changes in liquid CDS (LCDS) spreads lead to changes in illiquid CDS spreads at least one week ahead during the financial crisis period, whereas the leading direction is reversed during the post-crisis period. Moreover, the results are robust after controlling for structural variables which are proven as determinants of CDS spreads and are empirically supported. This study interprets that information was incorporated first into the LCDSs because of the flight-to-liquidity during the recent crisis period but there is a default contagion effect by reflecting illiquidity-induced credit risk after the crisis. Finally, the dynamic conditional correlation analysis also confirms the main results.
Highlights
Understanding and managing the risk of financial contagion are of importance because a whole of the financial system is likely to collapse when contagion effects are severe
We focus on examining whether there exists the flight-to-liquidity phenomenon and default contagion between liquid CDS (LCDS) and illiquid CDSs (ICDSs) when credit default swap (CDS) belong to the distressed assets because of the subprime mortgage defaults
We find that the LCDSs have developed significant predictive power for the ICDSs a week ahead during the crisis period but there is no leading effect by LCDSs during the pre- and post-crisis periods
Summary
Understanding and managing the risk of financial contagion are of importance because a whole of the financial system is likely to collapse when contagion effects are severe. Experiencing the recent financial crisis and the European debt crisis from 2007 to 2010, the participants of global financial markets realized that they had underestimated the contagion risk. The impact of contagion was more than they expected. This shock has led many studies to pay attention to contagion risk. Published in Journal of Derivatives and Quantitative Studies: 선물연구. The full terms of this licence may be seen at http:// creativecommons.org/licences/by/4.0/legalcode
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