Abstract
In this paper, we conduct the first empirical investigation into the impact of liquidity in the credit default swap index market on large complex financial institutions (LCFIs). We estimate this liquidity effect for the investment grade 5-year CDX North America and the investment grade 5-year iTraxx Europe. Using CDS data spanning three years, we document a strong positive link between changes in liquidity in the CDX and iTraxx index market and LCFIs equity returns and bid-ask spreads and find that that adjustments take place simultaneously. In addition, we show that CDX index liquidity shocks have even stronger effects to the European based-LCFIs. The US LCFIs are more prone to liquidity shocks in the iTraxx index market. Overall, the results support the hypothesis that contagion during the financial crisis was spread through a liquidity channel which, in turn, was associated with major portfolio rebalancing by LCFIs.
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