Financial Valuation and Risk Management Working Paper No . 590 Liquidity in the Foreign Exchange Market : Measurement , Commonality , and Risk Premiums

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.

[1]  Jonathan H. Wright,et al.  Trading Activity and Exchange Rates in High-Frequency EBS Data , 2007 .

[2]  Clara Vega,et al.  Rise of the Machines : Algorithmic Trading in the Foreign Exchange Market , 2009 .

[3]  Adrien Verdelhan,et al.  A Habit-Based Explanation of the Exchange Rate Risk Premium , 2009 .

[4]  R. Roll,et al.  A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market , 2008 .

[5]  Jiang Wang,et al.  Trading Volume and Serial Correlation in Stock Returns , 1992 .

[6]  Ohad Kadan,et al.  Limit Order Book as a Market for Liquidity , 2001 .

[7]  Ľuboš Pástor,et al.  Liquidity Risk and Expected Stock Returns , 2003, Journal of Political Economy.

[8]  Yihong Xia,et al.  International Capital Markets and Foreign Exchange Risk , 2004 .

[9]  Hanno Lustig,et al.  Note on The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk , 2007 .

[10]  G. Bekaert.  The Time Variation of Risk and Return in Foreign Exchange Markets: A General Equilibrium Perspective , 1994 .

[11]  S. Ross.  The arbitrage theory of capital asset pricing , 1976 .

[12]  E. Fama,et al.  Forward and spot exchange rates , 1984 .

[13]  M. Fleming.  Measuring Treasury Market Liquidity , 2001 .

[14]  Avanidhar Subrahmanyam,et al.  Market Liquidity and Trading Activity , 2000 .

[15]  Craig W. Holden,et al.  Do Liquidity Measures Measure Liquidity , 2009 .

[16]  Wayne E. Ferson,et al.  Finite sample properties of the generalized method of moments in tests of conditional asset pricing models , 1994 .

[17]  C. Engel.  The Risk Premium and the Liquidity Premium in Foreign Exchange Markets , 1992 .

[18]  Markus K. Brunnermeier,et al.  Carry Trades and Currency Crashes , 2008, NBER Macroeconomics Annual.

[19]  H. Shin,et al.  Carry Trades, Monetary Policy and Speculative Dynamics , 2011 .

[20]  Richard Roll,et al.  Commonality in Liquidity , 1999 .

[21]  Jonathan H. Wright,et al.  Order Flow and Exchange Rate Dynamics in Electronic Brokerage System Data , 2005 .

[22]  A. Shleifer,et al.  The Limits of Arbitrage , 1995 .

[23]  L. Hansen.  Large Sample Properties of Generalized Method of Moments Estimators , 1982 .

[24]  N. Roussanov,et al.  Common Risk Factors in Currency Markets , 2008 .

[25]  Duane J. Seppi,et al.  Common Factors in Prices, Order Flows and Liquidity , 1998 .

[26]  Chris I. Telmer,et al.  Affine Term Structure Models and the Forward Premium Anomaly , 2001 .

[27]  Christian T. Brownlees,et al.  Financial Econometric Analysis at Ultra-High Frequency: Data Handling Concerns , 2006, Comput. Stat. Data Anal..

[28]  P. Bacchetta,et al.  Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle , 2010 .

[29]  Lucio Sarno,et al.  Liquidity in the Foreign Exchange Market , 2011 .

[30]  Martin D. D. Evans,et al.  Order Flow and Exchange Rate Dynamics , 2002, Journal of Political Economy.

[31]  Mark P. Taylor,et al.  The Crisis in the Foreign Exchange Market , 2009, SSRN Electronic Journal.

[32]  Martin Eichenbaum,et al.  Do Peso Problems Explain the Returns to the Carry Trade? , 2008 .

[33]  Ioanid Roşu.  A Dynamic Model of the Limit Order Book , 2008 .

[34]  Francis Breedon,et al.  An empirical study of portfolio-balance and information effects of order flow on exchange rates , 2010 .

[35]  Markus K. Brunnermeier,et al.  Predatory Trading , 2003 .

[36]  Werner A. Stahel,et al.  Robust Statistics: The Approach Based on Influence Functions , 1987 .

[37]  Richard H. Thaler,et al.  Anomalies: Foreign Exchange , 1990 .

[38]  Richard K. Lyons,et al.  The Microstructure Approach to Exchange Rates , 2001 .

[39]  Y. Amihud,et al.  Illiquidity and Stock Returns: Cross-Section and Time-Series Effects , 2000 .

[40]  Charles M. C. Lee,et al.  Inferring Trade Direction from Intraday Data , 1991 .

[41]  H. Stoll.  THE SUPPLY OF DEALER SERVICES IN SECURITIES MARKETS , 1978 .

[42]  B. Ripley,et al.  Robust Statistics , 2018, Encyclopedia of Mathematical Geosciences.

[43]  Robert A. Korajczyk,et al.  Pricing the Commonality Across Alternative Measures of Liquidity , 2007 .

[44]  Wei Liu,et al.  Testing forward rate unbiasedness allowing for persistent regressors , 2005 .

[45]  Jürg M. Blum.  Why 'Basel II' May Need a Leverage Ratio Restriction , 2008 .

[46]  P. Mykland,et al.  How Often to Sample a Continuous-Time Process in the Presence of Market Microstructure Noise , 2003 .

[47]  L. Hansen,et al.  Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis , 1980, Journal of Political Economy.

[48]  Gady Jacoby,et al.  On Asset Pricing and the Bid-Ask Spread , 2001 .

[49]  Lan Zhang,et al.  A Tale of Two Time Scales , 2003 .

[50]  Tarun Chordia,et al.  An Empirical Analysis of Stock and Bond Market Liquidity , 2003 .

[51]  Geert Bekaert,et al.  Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets , 1991 .

[52]  Yacine Ait-Sahalia,et al.  How Often to Sample a Continuous-Time Process in the Presence of Market Microstructure Noise , 2003 .

[53]  V. Yohai,et al.  Robust Statistics: Theory and Methods , 2006 .

[54]  L. Pedersen,et al.  Asset Pricing with Liquidity Risk , 2003 .

[55]  Jialin Yu,et al.  High Frequency Market Microstructure Noise Estimates and Liquidity Measures , 2008, 0906.1444.

[56]  Lukas Menkhoff,et al.  Carry Trades and Global Foreign Exchange Volatility , 2011 .

[57]  Philippe Jorion,et al.  Currency Hedging for International Portfolios , 1993 .

[58]  Luis M. Viceira,et al.  Global Currency Hedging , 2007 .

[59]  W. Newey,et al.  A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelationconsistent Covariance Matrix , 1986 .

[60]  Andreas M. Fischer,et al.  Communicating Policy Options at the Zero Bound , 2008 .

[61]  I. Marsh,et al.  Customer Order Flow and Exchange Rate Movements: Is There Really Information Content? , 2005 .

[62]  Y. Amihud,et al.  Liquidity and Asset Prices , 2005 .

[63]  Lawrence Harris,et al.  Estimating the components of the bid/ask spread , 1988 .

[64]  I. -. London,et al.  An Empirical Study of Liquidity and Information Effects of Order Flow on Exchange Rates , 2005 .

[65]  Campbell R. Harvey,et al.  What Determines Expected International Asset Returns? , 1994 .

[66]  Campbell R. Harvey,et al.  Liquidity Management and Corporate Investment During a Financial Crisis , 2010 .

[67]  Joel Hasbrouck,et al.  Trading Costs and Returns for U.S. Equities: Estimating Effective Costs from Daily Data , 2009 .

[68]  Hendrik Bessembinder,et al.  Liquidity Biases in Asset Pricing Tests , 2009 .

[69]  Markus K. Brunnermeier,et al.  Market Liquidity and Funding Liquidity , 2005 .

[70]  Raphael A. Auer,et al.  The Effect of Low-Wage Import Competition on U.S. Inflationary Pressure , 2010 .

[71]  Francis Breedon,et al.  An Empirical Study of Liquidity and Information Effects of Order Flow on Exchange Rates , 2004, SSRN Electronic Journal.

[72]  Jiang Wang,et al.  The Illiquidity of Corporate Bonds , 2011 .

[73]  Craig W. Holden,et al.  New Low-Frequency Spread Measures , 2009 .

[74]  Sanford J. Grossman.  On the Impossibility of Informationally Efficient Markets , 1980 .

[75]  M. Fleming,et al.  Price Formation and Liquidity in the U.S. Treasury Market: The Response to Public Information , 1999 .

[76]  Intelligible factors for the yield curve , 2010 .

[77]  C. Engel,et al.  The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence , 1995 .

[78]  F. Hayashi,et al.  Emerging Market Currency Excess Returns , 2008 .

[79]  E. Fama,et al.  Common risk factors in the returns on stocks and bonds , 1993 .

[80]  Ronnie Sadka,et al.  Momentum and Post-Earnings-Announcement Drift Anomalies: The Role of Liquidity Risk , 2006 .

[81]  E. Ronchetti,et al.  Robust inference with GMM estimators , 2001 .

[82]  A. Kyle.  Continuous Auctions and Insider Trading , 1985 .

[83]  Ananth N. Madhavan,et al.  Why Do Security Prices Change? A Transaction-Level Analysis of Nyse Stocks , 1996 .

[84]  Charles M. Jones,et al.  Transactions, Volume, and Volatility , 1994 .

[85]  S. Morris,et al.  Liquidity Black Holes , 2003 .

[86]  E. Fehr,et al.  Competition and Relational Contracts , 2005 .

[87]  R. Green,et al.  Financial Valuation and Risk Management Working Paper No . 473 Price Discovery in Illiquid Markets : Do Financial Asset Prices Rise Faster Than They Fall ? , 2008 .

[88]  Angelo Ranaldo,et al.  Safe Haven Currencies , 2009 .