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Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums
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Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums
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Journal Article
Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums
2013
Overview
We provide the first systematic study of liquidity in the foreign exchange market. We find significant variation in liquidity across exchange rates, substantial illiquidity costs, and strong commonality in liquidity across currencies and with equity and bond markets. Analyzing the impact of liquidity risk on carry trades, we show that funding (investment) currencies offer insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong impact on carry trade returns from 2007 to 2009, suggesting that liquidity risk is priced. We present evidence that liquidity spirals may trigger these findings.
