Liquidity Connectedness in the Foreign Exchange Market

Abstract

We estimate the liquidity connectedness in the spot foreign exchange (FX) market based on an empirical network model. We find that the liquidity connectedness reflects the dynamic market uncertainties around the world. Supply- and demand-side factors are important drivers of liquidity connectedness, especially for the fear sentiment of investors and economic policy uncertainty. The relation between liquidity connectedness on the subsequent carry-trade return in the FX market is nonlinear and V-shaped. Overall, our research indicates that liquidity connectedness is a good measure of currency risk and can reflect the fragility of the FX market.