Trading Volume, Illiquidity and Commonalities in FX Markets
50 Pages Posted: 22 Nov 2018 Last revised: 14 Oct 2019
Date Written: October 14, 2019
In a regime of floating FX rates and open economies, it is important to understand the way through which FX rates, volatility, and trading volume interrelate. To uncover this, we provide a simple theoretical framework to jointly explore these factors in a multi-currency environment. Through the use of a unique intraday data representative for the global FX market, the empirical analysis validates our theoretical predictions: (i) more disagreement increases FX trading volume, volatility, and illiquidity, (ii) stronger commonalities pertain to more efficient (arbitrage-free) currencies, and (iii) the Amihud (2002) measure, for which we provide a theoretical underpinning, is effective in measuring FX illiquidity. Not only do these findings support an integrated analysis of FX rate evolution and risk, but our work also offers a straightforward method to measure FX illiquidity and commonality. For investors, these insights should increase the efficiency of trading and risk analysis. For policy makers, our work highlights the developments of FX global volume, volatility, and illiquidity across time and currencies, which can be important for the implementation of monetary policy and financial stability.
Keywords: FX Trading Volume, Volatility, Illiquidity, Commonalities, Arbitrage
JEL Classification: C15, F31, G12, G15
Suggested Citation: Suggested Citation