Financial Contagion and Market Liquidity - Evidence from the Asian Crisis
61 Pages Posted: 2 Mar 2005
Date Written: February 23, 2005
Models of financial crisis and contagion predict that an economic crisis turns into a financial liquidity crisis in the presence of borrowing constraints, information asymmetry and risk aversion, and it culminates in a crisis in market liquidity through portfolio recomposition. We use firm level data to examine changes in the stock market liquidity of exposed and unexposed firms to the Asian crisis. Our results indicate a significant increase in the crisis period bid-ask spreads and decrease in quoted depth for both exposed and unexposed firms, particularly the more liquid or less risky firms during the pre-crisis period. The drop in crisis period market liquidity seems to be attributable to an increase in margin-induced sales, risk aversion, and both the asymmetric information and fixed costs of trading. Finally, we find that the increase in liquidity costs provides a partial explanation for the crisis-induced abnormal returns.
Keywords: Contagion, Market Liquidity, Crisis
JEL Classification: F30, F40, G15
Suggested Citation: Suggested Citation