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Liquidity Commonality in Foreign Exchange Markets During the Global Financial Crisis and the Sovereign Debt Crisis: Effects of Macroeconomic and Quantitative Easing Announcements

Ya-Ting Chang, Yin-Feng Gau () and Chih-Chiang Hsu

The North American Journal of Economics and Finance, 2017, vol. 42, issue C, 172-192

Abstract: Noting the time-varying dynamics in liquidity, we use a generalized dynamic factor model (GDFM) to identify market-wide liquidity across foreign exchange (FX) markets. Liquidity commonality across currencies increases during the 2008–2009 global financial crisis and the 2009–2011 European sovereign debt crisis, which affirms the spiral effect between funding liquidity and FX market liquidity. The effect of funding constraint on liquidity in the FX market may be through carry trade activities that link the FX market and other classes of asset markets, as suggested by Melvin and Taylor (2009) and Banti (2016). The shift in liquidity commonality around the release of macroeconomic announcements also can be related to the spurs of unwinding carry trade positions in response to unexpected macro shock that affects interest rate differential. In contrast, quantitative easing (QE) policies in the United States, which inject high capital inflows into financial markets, are associated with decreased liquidity commonality, implying that QE implementation actually improves the funding liquidity and weakens the spiral effect, ultimately inducing weaker commonality in FX liquidity.

Keywords: Liquidity commonality; Macroeconomic announcements; Quantitative easing policies; Foreign exchange market (search for similar items in EconPapers)
JEL-codes: F31 G15 C22 (search for similar items in EconPapers)
Date: 2017
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