Illiquidity and volatility spillover effects in equity markets during and after the global financial crisis: an MEM approach

Even though the volatility spillover effects in global equity markets have been documented extensively, the transmission of illiquidity across national borders has not. In this paper, we propose a multiplicative error model (MEM) for the dynamics of illiquidity. We empirically study the illiquidity and volatility spillover effects in eight developed equity markets during and after the recent financial crisis. We find that equity markets are interdependent, both in terms of volatility and illiquidity. Most markets show an increase in volatility and illiquidity spillover effects during the crisis. Furthermore, we find volatility and illiquidity transmission are highly relevant. Illiquidity is a more important channel than volatility in propagating the shocks in equity markets. Our results show an overall crucial role for illiquidity in US markets in influencing other equity markets' illiquidity and volatility. These findings are of importance for policy makers as well as institutional and private investors.