This paper examines whether illiquidity propagates across equity and credit markets and, if so, through what mechanisms. Equity and CDS illiquidity co-movements are detected for a large sample of firms, but the extent of the illiquidity commonality changes over time and increases over crisis periods. For most firms illiquidity spills over from one market (CDS) to the other (equity).

We view equity and credit default swaps as claims written on the same underlying firm’s assets and show that, besides the effect of traders’ funding constraints, market volatility, and firm’s systematic risk the equity-CDS illiquidity co-movements are strongly related to the debtto-equity hedge ratio (based on the Merton 1974 model). The hedge ratio captures the arbitrage linkage between the two assets and the extent of cross-market activity of traders for hedging and speculative purposes and contributes to explain the existence of cross-market illiquidity spillovers.