Is It Liquidity or Quality that Matters More in Foreign Exchange Markets?

Abstract

ABSTRACT This article examines whether liquidity or credit quality (probability of default) “contributes” more to the explanation of currency excess returns, using two baskets of bilateral exchange rates—developed and emerging countries. My central finding is that US investors generally care only about liquidity when they invest in developed market currencies which are more liquid than emerging market currencies. During heightened market uncertainty, however, investors in developed market currencies also care about credit quality because only developed countries provide lower credit risk premia (i.e., hedge) during times of tension when currency traders generally tend to rebalance their portfolios toward currencies with lower probability of default. Conversely, US investors in emerging market currencies demand a credit risk premium since they are concerned about credit quality of these countries.