Global Liquidity Risk in the Foreign Exchange Market
50 Pages Posted: 4 Nov 2011
Date Written: October 11, 2011
Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analogue of the well-known Pastor-Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.
Keywords: foreign exchange, liquidity, order flow, microstructure
JEL Classification: F31, F37, G12, G15
Suggested Citation: Suggested Citation