Abstract
We examine illiquidity spillovers between credit default swap (CDS) and equity markets, proposing that increased CDS illiquidity decreases liquidity provision by equity market makers who use CDS prices as signals of firm value. To motivate this mechanism, we extend a model of insider trading to include a cross-market signal of firm value. Regression analyses confirm significant co-movements between measures of equity illiquidity and lagged measures of CDS price noisiness. This interconnectedness has important implications for equity market quality: when CDS markets become more illiquid, stocks with CDS contracts face greater price impact and higher illiquidity than stocks without CDS traded.
Published Version
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