FX Liquidity Risk and Carry Trade Premia

55 Pages Posted: 29 Mar 2022 Last revised: 2 Nov 2022

See all articles by Paul Söderlind

Paul Söderlind

University of St. Gallen

Fabricius Somogyi

D’Amore-McKim School of Business

Date Written: March 26, 2022

Abstract

The currency market is the largest and presumably most liquid financial market in the world. We show that even in this highly liquid market exposure to liquidity risk commands a nontrivial risk premium of up to 3.6% per annum. However, we also find that liquidity risk and carry trade premia are significantly correlated. We show that the commonality is only confined to the static but not the dynamic carry trade. Lastly, we use a novel instrument based on monetary policy announcement dates to provide causal evidence that changes in interest rates affect the composition of liquidity risk sorted portfolios.

Keywords: Currency portfolios, Carry trade returns, FX liquidity risk, Liquidity risk premium

JEL Classification: G12, G15, F31

Suggested Citation

Söderlind, Paul and Somogyi, Fabricius, FX Liquidity Risk and Carry Trade Premia (March 26, 2022). University of St.Gallen, School of Finance Research Paper No. 2022/02, Northeastern U. D’Amore-McKim School of Business Research Paper No. 4067387, Available at SSRN: https://ssrn.com/abstract=4067387 or http://dx.doi.org/10.2139/ssrn.4067387

Paul Söderlind

University of St. Gallen ( email )

Rosenbergstrasse 52
St. Gallen, 9000
Switzerland
+41 71 224 7064 (Phone)
+41 71 224 7088 (Fax)

HOME PAGE: http://https://sites.google.com/site/paulsoderlindecon/home

Fabricius Somogyi (Contact Author)

D’Amore-McKim School of Business ( email )

360 Huntington Ave.
Boston, MA 02115
United States

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