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FX Liquidity Risk and Carry Trade Returns

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “FX Liquidity Risk and Carry Trade Returns” delves into the nuanced relationship between FX liquidity risk and carry trade returns, offering valuable insights into the impact of low-frequency market-wide liquidity measures on currency market dynamics.

Particularly, the study employs a liquidity-based ranking of currency pairs to construct a mimicking liquidity risk factor, unveiling its efficacy in elucidating the variation of carry trade returns across different exchange rate regimes. Through a liquidity-adjusted asset pricing framework, the paper demonstrates that a significant portion of the variation in carry trade returns can be ascribed to two pivotal risk factors – market and liquidity risk – within the FX market, underscoring their profound influence.

Moreover, the results are reinforced by the substitution of the hedge liquidity risk factor with a non-tradable innovations risk factor.

This holistic analysis propels our comprehension of FX liquidity dynamics, carry trade strategies, and the intricate interplay between risk factors and exchange rate regimes, contributing to the ongoing discourse on currency market volatility and investment strategies.

Abstract Of Paper

We study the effects of FX liquidity risk on carry trade returns using a low-frequency market-wide liquidity measure. We show that a liquidity-based ranking of currency pairs can be used to construct a mimicking liquidity risk factor, which helps in explaining the variation of carry trade returns across exchange rate regimes. In a liquidity-adjusted asset pricing framework, we show that the vast majority of variation in carry trade returns during any exchange rate regime can be explained by two risk factors (market and liquidity risk) in the FX market. Our results are further corroborated when the hedge liquidity risk factor is replaced with a non-tradable innovations risk factor.

Original paper – Download PDF

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Author

Samuel Abankwa
University of North Carolina (UNC) at Charlotte – The Belk College of Business Administration

Lloyd P. Blenman
University of North Carolina (UNC) at Charlotte – Department of Finance & Business Law

Conclusion

In conclusion, “FX Liquidity Risk and Carry Trade Returns” provides compelling insights into the interplay between FX liquidity risk and carry trade returns, significantly enriching our understanding of currency market dynamics.

The study underscores the utility of a low-frequency market-wide liquidity measure and a liquidity-based ranking of currency pairs in constructing a mimicking liquidity risk factor, which effectively elucidates the variation of carry trade returns across diverse exchange rate regimes. Through a liquidity-adjusted asset pricing framework, the research convincingly demonstrates that the predominant variance in carry trade returns during any exchange rate regime can be attributed to two pivotal risk factors – market and liquidity risk – within the FX market.

Notably, the substitution of the hedge liquidity risk factor with a non-tradable innovations risk factor further corroborates the robustness of these findings.

This comprehensive analysis contributes substantially to our comprehension of FX liquidity dynamics, carry trade strategies, and the multifaceted nature of risk factors in the currency market, advancing the ongoing discourse on investment strategies and currency market volatility.

Related Reading:

Currency Premia and Global Imbalances

Carry and Trend Following Returns in the Foreign Exchange Market

FAQ

Q1: What is the focus of the research paper “FX Liquidity Risk and Carry Trade Returns”?

A1: The research paper focuses on exploring the relationship between FX liquidity risk and carry trade returns. It employs a low-frequency market-wide liquidity measure to construct a mimicking liquidity risk factor, examining its impact on carry trade returns across different exchange rate regimes.

Q2: How does the paper contribute to understanding carry trade returns in the FX market?

A2: The paper contributes to understanding carry trade returns by demonstrating that a significant portion of the variation in carry trade returns during any exchange rate regime can be explained by two key risk factors in the FX market – market risk and liquidity risk. The study employs a liquidity-adjusted asset pricing framework and highlights the influence of these risk factors on carry trade returns.

Q3: What role does the mimicking liquidity risk factor play in the study’s findings?

A3: The mimicking liquidity risk factor, constructed based on a liquidity-based ranking of currency pairs, is instrumental in explaining the variation of carry trade returns across different exchange rate regimes. It serves as a valuable tool in assessing the impact of FX liquidity risk on carry trade dynamics and contributes to the overall understanding of risk factors in the currency market.

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