Abstract
Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.
Highlights
The foreign exchange (FX) market is considered to be highly liquid
Given that there is a common component in the cost of providing liquidity in the FX market, it seems reasonable to expect the time-variation in liquidity to be correlated across currencies
The results indicate that the liquidity risk premium estimated via General Method of Moments (GMM) is lower than the one recorded earlier at around 3 percent but still strongly statistically signi...cant with a t-statistic of 8.36
Summary
The foreign exchange (FX) market is considered to be highly liquid. The average daily market activity in April 2010 was $3.98 trillion (BIS, 2010). There are large di¤erences across currencies: 66 percent of the FX market average daily turnover in April 2010 involves the six most traded pairs of currencies. Using a unique data set comprising daily order ‡ow for 20 exchange rates spanning 14 years, we build a measure of liquidity inspired by the Pastor and Stambaugh (2003) measure, which was originally developed for the US stock market. Analyzing the properties of the individual currency liquidity measures, we ...nd that they are highly correlated, suggesting the presence of a common component across them. The presence of a common component is consistent with the notion that liquidity is largely driven by shocks that a¤ect the FX market as a whole rather than individual currencies. We construct a measure of innovations in global FX liquidity (unexpected liquidity) and show that it explains a sizeable share of liquidity ‡uctuations in individual currencies
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