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FX market liquidity, funding constraints and capital flows

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  • Banti, Chiara
  • Phylaktis, Kate

Abstract

We investigate the determinants of the time variation of the common component of FX market liquidity across developed and emerging market currencies. We study the impact of funding liquidity constraints, which proxy for supply considerations, and capital flows, which proxy for demand considerations of liquidity on transaction costs. Our results show that (i) funding liquidity constraints measured by the availability of outstanding repos reduce FX market liquidity, and their impact is stronger when they are associated with an increase in the costs of funding and a shortening of their maturity; (ii) increasing capital flows at the global level increase liquidity; (iii) both of these effects were stronger during the recent financial crisis, when liquidity dry-ups were severe; and (iv) the analysis of individual currencies with diverse riskiness confirms that a shock to speculator capital would lead to a reduction in market liquidity through a spiral effect that is stronger for more volatile currencies. Furthermore, we find a similar effect related to capital flows.

Suggested Citation

  • Banti, Chiara & Phylaktis, Kate, 2015. "FX market liquidity, funding constraints and capital flows," Journal of International Money and Finance, Elsevier, vol. 56(C), pages 114-134.
  • Handle: RePEc:eee:jimfin:v:56:y:2015:i:c:p:114-134
    DOI: 10.1016/j.jimonfin.2014.11.002
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    References listed on IDEAS

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    2. repec:bla:jfnres:v:39:y:2016:i:4:p:411-436 is not listed on IDEAS
    3. Sheng Huang & Jonathan Williams & Ru Xie, 2017. "The Future of Money: Liquidity co-movement between financial institutions and real estate firms: evidence from China," Working Papers 17004, Bangor Business School, Prifysgol Bangor University (Cymru / Wales).
    4. repec:eee:jimfin:v:93:y:2019:i:c:p:277-298 is not listed on IDEAS
    5. Thapa, Chandra & Neupane, Suman & Marshall, Andrew, 2016. "Market liquidity risks of foreign exchange derivatives and cross-country equity portfolio allocations," Journal of Multinational Financial Management, Elsevier, vol. 34(C), pages 46-64.
    6. Orlov, Vitaly, 2016. "Currency momentum, carry trade, and market illiquidity," Journal of Banking & Finance, Elsevier, vol. 67(C), pages 1-11.
    7. Ingomar Krohn & Vladyslav Sushko, 2017. "Liquidity in FX spot and forward markets," GRU Working Paper Series GRU_2017_019, City University of Hong Kong, Department of Economics and Finance, Global Research Unit.

    More about this item

    Keywords

    Foreign exchange; Liquidity; Funding liquidity constraints; Capital flows; Microstructure;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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