Liquidity Risk and Currency Premia

Paul Söderlind () and Fabricius Somogyi ()
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Paul Söderlind: Swiss Institute of Banking and Finance, University of St. Gallen, 9000 St. Gallen, Switzerland
Fabricius Somogyi: D’Amore-McKim School of Business, Northeastern University, Boston, Massachusetts 02115

Management Science, 2025, vol. 71, issue 1, 518-537

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 on 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 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:71:y:2025:i:1:p:518-537

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