FX Liquidity Risk and Carry Trade Returns

A new related paper has been added to:

#5 – FX Carry Trade

Authors: Abankwa, Blenman

Title: FX Liquidity Risk and Carry Trade Returns

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2662955

Abstract:

We study the effects of FX liquidity risk on carry trade returns using a low-frequency market-wide liquidity measure. We show that a liquidity-based ranking of currency pairs can be used to construct a mimicking liquidity risk factor, which helps in explaining the variation of carry trade returns across exchange rate regimes. In a liquidity-adjusted asset pricing framework, we show that the vast majority of variation in carry trade returns during any exchange rate regime can be explained by two risk factors (market and liquidity risk) in the FX market. Our results are further corroborated when the hedge liquidity risk factor is replaced with a non-tradable innovations risk factor.

Notable quotations from the academic research paper:

"Academic research used to ignore liquidity. The theory assumed frictionless markets which are perfectly liquid all of the time. This paper takes the opposite view. We argue that illiquidity is a central feature of the securities and financial markets. This paper provides a comprehensive study that links liquidity risk to carry trade returns and provides an explanation of why currency investors should consider and manage FX liquidity risk.  The paper contributes to the international finance and empirical asset pricing literature in three major perspectives.

This is the first study to investigate the effects of liquidity risk on carry trade returns across exchange rate regimes, using a low-frequency market-wide liquidity measure constructed from daily transaction prices. The possibility of using a low-frequency (LF) liquidity measure circumvents the restricted and costly access of intraday high-frequency (HF) data. Not only is access to HF data limited and costly, it is also subjected to time-consuming handling, cleaning, and filtering techniques.

Second, we show that FX liquidity risk can be gleaned from the low-frequency market-wide liquidity measure, which helps in explaining the variation of carry trade returns in an asset pricing framework.

Third, we find that liquid and illiquid G10 currencies behave dierently toward liquidity risk for all regimes. Whereas liquid currencies such as the JPY and EUR are not that sensitive to liquidity risk, illiquid currencies such as the AUD and NZD are highly sensitive to liquidity risk. Liquid currencies have negative liquidity betas whereas illiquid currencies show positive liquidity betas. This also substantiates the finding by Mancini, Ranaldo, and Wrampelmeyer (2013) that negative liquidity beta currencies act as insurance or liquidity hedge, whereas positive liquidity beta currencies expose currency investors to liquidity risk."

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