Contagion between Liquid and Illiquid Assets during the Financial Crisis: Evidence from the US Credit Derivative Market

This study investigates the existence of contagion between liquid and illiquid assets in the credit default swap (CDS) market around the recent financial crisis. We 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 spreads lead 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 empirically supported. Finally, the dynamic conditional correlation analysis also confirms our main results. Therefore, we interpret that information was incorporated first into the liquid CDSs due to the flight-to-liquidity during the recent crisis period but there’s default contagion effect by reflecting illiquidity-induced credit risk after the crisis.