FX Liquidity Risk and Carry Trade Returns

45 Pages Posted: 26 Sep 2015 Last revised: 30 Nov 2015

See all articles by Samuel Abankwa

Samuel Abankwa

University of North Carolina (UNC) at Charlotte - The Belk College of Business Administration

Lloyd P. Blenman

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law

Date Written: November 11, 2015

Abstract

We study the effects of FX liquidity risk on carry trade returns using a low-frequency market-wide liquidity measure. We show that a liquidity-based ranking of currency pairs can be used to construct a mimicking liquidity risk factor, which helps in explaining the variation of carry trade returns across exchange rate regimes. In a liquidity-adjusted asset pricing framework, we show that the vast majority of variation in carry trade returns during any exchange rate regime can be explained by two risk factors (market and liquidity risk) in the FX market. Our results are further corroborated when the hedge liquidity risk factor is replaced with a non-tradable innovations risk factor.

Keywords: FX Liquidity Risk, Exchange Rate Regimes, Carry Trade Returns, Forward Premium Puzzle

JEL Classification: C10, F31, G12, G15

Suggested Citation

Abankwa, Samuel and Blenman, Lloyd P., FX Liquidity Risk and Carry Trade Returns (November 11, 2015). Available at SSRN: https://ssrn.com/abstract=2662955 or http://dx.doi.org/10.2139/ssrn.2662955

Samuel Abankwa

University of North Carolina (UNC) at Charlotte - The Belk College of Business Administration ( email )

9201 University City Boulevard
Charlotte, NC 28223-0001
United States
704-687-7356 (Phone)

HOME PAGE: http://https://belkcollegeofbusiness.uncc.edu/sabankwa/

Lloyd P. Blenman (Contact Author)

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704-687-7705 (Phone)

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