Liquidity Risk and Currency Premia

Abstract

The currency market is the world's largest financial market by trading volume. We show that even in this highly liquid market exposure to liquidity risk commands an economically significant risk premium of up to 3.6% per year. Liquidity risk is not subsumed by existing currency risk factors and successfully prices the cross-section of currency excess returns. Moreover, we find that liquidity risk and carry trade premia are correlated, although this correlation is limited to static rather than dynamic carry trades. Building upon this result, we propose a liquidity-based explanation for the carry trade, which adds significant explanatory power to existing theories.

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

JEL Classification: G12, G15, F31