Exchange Rates and Liquidity Risk

Martin Evans

MPRA Paper from University Library of Munich, Germany

Abstract: I use Forex trading data to study how risks associated with the lack of liquidity contribute to the dynamics of 17 spot exchange rates through their time-varying contributions to risk premia. I find that liquidity risk matters. All the foreign exchange risk premia compensate investors for exposure to liquidity risk; and, for many currencies, exposure to liquidity risk appears to be more important than exposure to the traditional carry and momentum risk factors. I also find that variations in the price of liquidity risk make economically important contributions to the behavior of individual foreign currency returns: they account for approximately 34 percent, on average, of the variability in currency returns compared to the contribution of approximately 8 percent from the prices of carry and momentum risk.

Keywords: Foreign Currency Trading; Liquidity; Returns; Risk Premia; and Risk Factors (search for similar items in EconPapers)
JEL-codes: F3 F4 G1 (search for similar items in EconPapers)
Date: 2020-08-31
New Economics Papers: this item is included in nep-ifn and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:102702

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