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

  • Loriano Mancini
  • Angelo Ranaldo
  • Jan Wrampelmeyer

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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File URL: http://www.snb.ch/n/mmr/reference/working_paper_2010_03/source/working_paper_2010_03.n.pdf
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Paper provided by Swiss National Bank in its series Working Papers with number 2010-03.

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Length: 65 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:snb:snbwpa:2010-03
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