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Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums
Journal
Journal of Finance
ISSN
0022-1082
ISSN-Digital
1540-6261
Type
journal article
Date Issued
2013-10
Author(s)
Abstract
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. We analyze the impact of liquidity risk on carry trades,
a popular trading strategy that borrows in low-yielding currencies and invests in
high-yielding currencies. Results 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.
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. We analyze the impact of liquidity risk on carry trades,
a popular trading strategy that borrows in low-yielding currencies and invests in
high-yielding currencies. Results 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.
Language
English
HSG Classification
contribution to scientific community
Refereed
Yes
Publisher
Wiley-Blackwell
Publisher place
Oxford
Volume
68
Number
5
Start page
1805
End page
1841
Pages
37
Subject(s)
Eprints ID
214648