FX Liquidity Risk and Carry Trade Premia
55 Pages Posted: 29 Mar 2022 Last revised: 2 Nov 2022
Date Written: March 26, 2022
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: Suggested Citation