Illiquidity in the stock and foreign exchange markets: an investigation of their cross-market dynamics

In this article, I investigate the illiquidity channel linking stocks and currencies and provide evidence of important illiquidity dynamics, especially during crisis episodes. I show that the stocks of small firms more exposed to funding constraints also exhibit greater linkages with foreign exchange illiquidity. Furthermore, the currencies that are common targets of carry trades are more intertwined with stock illiquidity. Regarding potential determinants, the liquidity demand by institutional investors and liquidity provision by dealers are potential triggers of systemic illiquidity spirals. These dynamics are not exclusive to the recent financial crisis but were also present during the dot‐com bubble crisis.