Liquidity in the Foreign Exchange Market: Measurement, Commonality,and Risk Premiums

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  • 1 January 2009
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      • Published in RePEc
Abstract
This paper develops a liquidity measure tailored to the foreign exchange (FX) market, quanti fies the amount of commonality in liquidity across different exchange rates, and determines the extent of liquidity risk premiums embedded in FX returns. The new liquidity measure utilizes ultra high frequency data and captures cross-sectional and temporal variation in FX liquidity during the financial crisis of 2007-2008. As sudden shocks to market-wide liquidity have important implications for regulators and investors, liquidity is decomposed into an idiosyncratic and a common component. Empirical results show that liquidity co-moves strongly across currency pairs and that systematic FX liquidity decreases dramatically during the financial crisis. To investigate whether investors require a return premium for bearing liquidity risk, a factor model for FX returns is extended by a novel liquidity risk factor constructed from shocks to market-wide liquidity. Estimation results suggest that liquidity risk is a heavily priced state variable.
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