Carry Trade and Liquidity Risk: Evidence from forward and Cross-Currency Swap Markets
35 Pages Posted: 20 Sep 2012
Date Written: August 28, 2012
This study empirically examines the effect of foreign exchange (FX) market liquidity risk and volatility on the excess returns of currency carry trades. In contrast to the existent literature, we construct an alternative proxy of liquidity risk - violations of no arbitrage bounds in the forward and currency swap markets. We also use volatility smile data to capture FX-market specific volatility. The sample data cover periods both before and after the Global Financial Crisis (GFC). Both proxies are significant in explaining the abnormal returns of carry trades, particularly after the GFC. Our findings provide substantial evidence that uncovered interest parity (UIP) puzzle can be resolved after controlling for liquidity risk and market volatility.
Keywords: uncovered interest rate parity, carry trade, liquidity risk, no-arbitrage bound, volatility
JEL Classification: F31, G15
Suggested Citation: Suggested Citation