Exchange Rates and Liquidity Risk

Abstract

I use Forex trading data to study how risks associated with the lack of liquidity contribute to the dynamics of 17 spot exchange rates through their time-varying contributions to risk premia. I find that liquidity risk matters. All the foreign exchange risk premia compensate investors for exposure to liquidity risk; and, for many currencies, exposure to liquidity risk appears to be more important than exposure to the traditional carry and momentum risk factors. I also find that variations in the price of liquidity risk make economically important contributions to the behavior of individual foreign currency returns: they account for approximately 34 percent, on average, of the variability in currency returns compared to the contribution of approximately 8 percent from the prices of carry and momentum risk.

Keywords: Foreign Currency Trading, Liquidity, Returns, Risk Premia, and Risk Factors

JEL Classification: F3; F4; G1