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

• Author: Lars Helge Haß,Denis Schweizer,Christian Koziol
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12011.x
• Published date: 01 June 2014
• Date: 01 June 2014

What Drives Contagion in Financial

Markets? Liquidity Effects versus

Information Spill‐Over

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 financial markets by

identifying the mechanisms which drive the spill‐over of shocks from one market to

other markets. To address this question we use open‐ended property funds (OPFs)

as they offer a unique institutional setting which allows separating between

liquidity and information spill‐over. We find 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: financial contagion, information spill‐over, open‐ended 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, 548–573

doi: 10.1111/j.1468-036X.2013.12011.x

© 2013 John Wiley & Sons Ltd

1. Introduction

The collapse of the well‐established investment bank Lehman Brothers in September 2008

marked the starting point of the US subprime mortgage crisis, which progressed to a

global financial 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 financial 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 first suggests that negative shocks in one market can be

regarded as new economic information which directly affects the underlying value and/or

linked cash flows 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 find 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 ‘flight to quality’. In this mechanism, contagion

occurs through a liquidity shock across other financial 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 time‐varying (liquidity) risk premium (mechanism 2).

The objective of this paper is to analyse how the two types of contagion, information

spill‐over, 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 open‐ended property funds (OPFs) market. OPFs are

essentially a compromise between direct and listed real estate investments. Fund

managers invest directly in an internationally diversified real estate portfolio, while

holding a cash‐equivalent position ranging from 5% to 49% of assets under management

for daily liquidity. Once an OPF’s 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 sufficient new

asset inflows 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

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