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Carry Trade and Liquidity Risk: Evidence from forward and Cross-Currency Swap Markets

35 Pages Posted: 20 Sep 2012

See all articles by Yang Chang

Yang Chang

School of Risk and Actuarial Studies, ARC Center of Excellence in Population Ageing Research (CEPAR); Quantitative Finance Research Centre

Erik Schlögl

University of Technology Sydney (UTS), Quantitative Finance Research Centre; University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management; Faculty of Science, Department of Statistics, University of Johannesburg; Financial Research Network (FIRN)

Date Written: August 28, 2012

Abstract

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

Chang, Yang and Schloegl, Erik, Carry Trade and Liquidity Risk: Evidence from forward and Cross-Currency Swap Markets (August 28, 2012). Available at SSRN: https://ssrn.com/abstract=2137444 or http://dx.doi.org/10.2139/ssrn.2137444

Yang Chang

School of Risk and Actuarial Studies, ARC Center of Excellence in Population Ageing Research (CEPAR) ( email )

Australian School of Business Building
University of New South Wales
Sydney, New South Wales NSW 2052
Australia

Quantitative Finance Research Centre ( email )

University of Technology, Sydney
Sydney, New South Wales 2000
Australia

Erik Schloegl (Contact Author)

University of Technology Sydney (UTS), Quantitative Finance Research Centre ( email )

Ultimo
PO Box 123
Sydney, NSW 2007
Australia
+61 2 9514 2535 (Phone)

HOME PAGE: http://www.schlogl.com

University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management ( email )

Leslie Commerce Building
Rondebosch
Cape Town, Western Cape 7700
South Africa

Faculty of Science, Department of Statistics, University of Johannesburg ( email )

Auckland Park, 2006
South Africa

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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