Liquidity contagion: A look at emerging markets

Emerging economies have passed an important stress test during the period 2008-09 andare now the key drivers for global growth of the world economy. Financial markets are todayso inter connected that they are fragile to contagion. The issue of financial contagion washistorically concerning Emerging Markets (EM). These latter attract foreign investors andmassive investments funds in - and out - flows on very short horizons can be a source of contagion effects between markets. The analysis of the sovereign debt markets and particularlyrelated CDS markets is of interest since it is at the very center of a new phenomenon: banksare not any more the main source of systemic risk but sovereign economies are. As foreigninvestors represent the most of the volume traded, capital flows in these markets should also impact FX market. Their analysis is thus also central to this study. Indeed, the mainrisk for an asset manager is to get stuck with unwanted sovereign debt due to a dry up ofmarket liquidity. The main contribution of this paper is the analysis of contagion looking atcommon markets liquidity problems to detect funding liquidity problems. We use the CreditDefault Swap bond spread basis and the deviations from the Covered Interest Parity as liquidity measures respectively for sovereign debt and FX markets. Moreover, we distinguishinterdependence and pure contagion using a state-space model with a time - varying volatilityspecification and we apply it to both returns and liquidity indicators.