Exchange Rates and Liquidity Risk

Evans, Martin (2020): Exchange Rates and Liquidity Risk.

Abstract

I use Forex trading data to study how risks associated with the lack of liquidity contribute to the dynamics of 17 spot exchange rates through their time-varying contributions to risk premia. I find that liquidity risk matters. All the foreign exchange risk premia compensate investors for exposure to liquidity risk; and, for many currencies, exposure to liquidity risk appears to be more important than exposure to the traditional carry and momentum risk factors. I also find that variations in the price of liquidity risk make economically important contributions to the behavior of individual foreign currency returns: they account for approximately 34 percent, on average, of the variability in currency returns compared to the contribution of approximately 8 percent from the prices of carry and momentum risk.

• Item Type: MPRA Paper
• Language: English
• Keywords: Foreign Currency Trading, Liquidity, Returns, Risk Premia, and Risk Factors
• Subjects: F - International Economics > F3 - International Finance; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance; G - Financial Economics > G1 - General Financial Markets

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