Carry Trade and Liquidity Risk: Evidence from Forward and Cross-Currency Swap Markets

Erik Schlogl and Yang Chang

No 310, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: This study empirically examines the effect of foreign exchange (FX) market liquidity risk and volatility on the excess returns of currency carry trades. In contrast to the existent literature, we construct an alternative proxy of liquidity risk - violations of no arbitrage bounds in the forward and currency swap markets. We also use volatility smile data to capture FX-market specific volatility. The sample data cover periods both before and after the Global Financial Crisis (GFC). Both proxies are significant in explaining the abnormal returns of carry trades, particularly after the GFC. Our findings provide substantial evidence that uncovered interest parity (UIP) puzzle can be resolved after controlling for liquidity risk and market volatility.

Keywords: uncovered interest rate parity; carry trade; liquidity risk; no-arbitrage bound; volatility (search for similar items in EconPapers)
JEL-codes: F31 G15 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2012-08-01
New Economics Papers: this item is included in nep-ifn, nep-mst and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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