What Drives Contagion in Financial Markets? Liquidity Effects versus Information Spill‐Over

DOIhttp://doi.org/10.1111/j.1468-036X.2013.12011.x
Published date01 June 2014
Date01 June 2014
What Drives Contagion in Financial
Markets? Liquidity Effects versus
Information SpillOver
Lars Helge Haß
Lancaster University Management School, Lancaster University, Lancaster, LA1 4YX UK
E-mail: l.h.hass@lancaster.ac.uk
Christian Koziol
University of Tübingen, Department of Finance, Nauklerstraße 4772074 Tübingen, Germany
E-mail: christian.koziol@uni-tuebingen.de
Denis Schweizer
WHU Otto Beisheim School of Management, Burgplatz 256179 Vallendar, Germany
E-mail: Denis.Schweizer@whu.edu
Abstract
The objective of this paper is to study how contagion works in nancial markets by
identifying the mechanisms which drive the spillover of shocks from one market to
other markets. To address this question we use openended property funds (OPFs)
as they offer a unique institutional setting which allows separating between
liquidity and information spillover. We nd that that liquidity risk captures the
observed discounts very well when the danger of potential future impairments is
low. Once the impending NAV impairments become very likely, also this component
matters and attributes for a fraction of the total discount.
Keywords: nancial contagion, information spillover, openended property funds
JEL classification: G1, G14
We are very grateful to an anonymous referee for many helpful comments and to the editor
John Doukas for very useful suggestions. Moreover, we would like to thank Yakov
Amihud, Douglas Cumming, Wenxuan Hou, Randy Priem, Marcel Tyrell as well as the
participants of the EFM Alternative Investments Conference 2011 and Campus for Finance
2011 for helpful comments and suggestions. We also thank Kay Homann from Börse
Hamburg for providing access to their databases and Pascal Noel for excellent research
assistance. All remaining errors are our own.
European Financial Management, Vol. 20, No. 3, 2014, 548573
doi: 10.1111/j.1468-036X.2013.12011.x
© 2013 John Wiley & Sons Ltd
1. Introduction
The collapse of the wellestablished investment bank Lehman Brothers in September 2008
marked the starting point of the US subprime mortgage crisis, which progressed to a
global nancial crisis. Triggered by the threat of extensive defaults on subprime
mortgages, markets have suffered catastrophic losses in the subsequent years (Fabozzi
et al., 2010). Even at its early stages, markets feared that the subprime crisis might spill
over into other sectors of the economy (see, e.g., Stein, 2010; Hamalainen et al., 2012). As
the crisis has unfolded, a number of these fears have been realized, with large negative
shocks in the housing, equity, municipal bond, real estate, and corporate debt markets,
among others. This escalation plainly demonstrates how contagion can spread from a
local crisis to affect global nancial markets (see, e.g., Longstaff, 2010).
There is an extensive literature dealing with the causes and effects of contagion
1
, with
two major strands of research. The rst suggests that negative shocks in one market can be
regarded as new economic information which directly affects the underlying value and/or
linked cash ows associated with securities in other markets (see, e.g., Kiyotaki and
Moore, 2002; Kaminsky et al., 2003). In this mechanism, contagion can be viewed as the
transmission of information from more liquid markets or markets with more rapid price
discovery to other markets (mechanism 1).
The second strand of research addresses how investors who suffer losses in one market
may nd their ability to obtain funding impaired (see, e.g., Allen and Gale, 2004;
Brunnermeier and Pedersen, 2005). This leads to a downward spiral in overall market
liquidity and other asset prices via a ight to quality. In this mechanism, contagion
occurs through a liquidity shock across other nancial markets. Vayanos (2004), Acharya
and Pedersen (2005), Longstaff (2008) and others, extend this argument by proposing that
a negative shock in one market may be associated with an increase in the (liquidity) risk
premium in other markets, leading to a reduction in marketability. In this mechanism,
contagion occurs as negative returns in the distressed market, which affects subsequent
returns in other markets via the timevarying (liquidity) risk premium (mechanism 2).
The objective of this paper is to analyse how the two types of contagion, information
spillover, and the liquidity risk premium initiated by the crisis in the US subprime
segment have affected price determination in other markets, and which source of
contagion predominates (see Gorton (2009) for an excellent chronological sequence of the
crisis and the responsible drivers). A particular market segment for which both types of
contagion are a major issue is the openended property funds (OPFs) market. OPFs are
essentially a compromise between direct and listed real estate investments. Fund
managers invest directly in an internationally diversied real estate portfolio, while
holding a cashequivalent position ranging from 5% to 49% of assets under management
for daily liquidity. Once an OPFs liquidity falls below 5%, the fund must temporarily
suspend share redemptions; investors can then no longer redeem their shares at the
redemption price (net asset value (NAV) of the portfolio properties plus the cash/bonds
position). Fund managers then have a maximum of 2 years to either attract sufcient new
asset inows and/or liquidate portfolio properties to again ensure fund liquidity. During
this time, investors can sell their shares only in a secondary market, at the prevailing
1
Detailed surveys can be found in Kindleberger (1978), Dornbusch et al. (2000), and
Kaminsky et al. (2003).
© 2013 John Wiley & Sons Ltd
What Drives Contagion in Financial Markets 549

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