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Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

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  • LORIANO MANCINI
  • ANGELO RANALDO
  • JAN WRAMPELMEYER

Abstract

This paper develops a liquidity measure tailored to the foreign exchange (FX) market, quantifies the amount of commonality in liquidity across exchange rates, and determines the extent of liquidity risk premiums embedded in FX returns. The new liquidity measure utilizes ultra high frequency data and captures cross-sectional and temporal variation in FX liquidity during the financial crisis of 2007-2008. Empirical results show that liquidity co-moves across currency pairs and that systematic FX liquidity decreases dramatically during the crisis. Extending an asset pricing model for FX returns by the novel liquidity risk factor suggests that liquidity risk is heavily priced.
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Suggested Citation

  • Loriano Mancini & Angelo Ranaldo & Jan Wrampelmeyer, 2013. "Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums," Journal of Finance, American Finance Association, vol. 68(5), pages 1805-1841, October.
  • Handle: RePEc:bla:jfinan:v:68:y:2013:i:5:p:1805-1841
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    File URL: http://hdl.handle.net/10.1111/jofi.2013.68.issue-5
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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