Liquidity Risk and Currency Premia

Management Science, Forthcoming

92 Pages Posted: 29 Mar 2022 Last revised: 25 Mar 2024

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 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

Suggested Citation

Söderlind, Paul and Somogyi, Fabricius, Liquidity Risk and Currency Premia (March 26, 2022). Management Science, Forthcoming, 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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