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Carry Trade and Liquidity Risk: Evidence from Forward and Cross-Currency Swap Markets



This study empirically examines the effect of foreign exchange (FX) market liquidity risk and volatility on the excess returns of currency carry trades. In contrast to the existent literature, we construct an alternative proxy of liquidity risk - violations of no arbitrage bounds in the forward and currency swap markets. We also use volatility smile data to capture FX-market specific volatility. The sample data cover periods both before and after the Global Financial Crisis (GFC). Both proxies are significant in explaining the abnormal returns of carry trades, particularly after the GFC. Our findings provide substantial evidence that uncovered interest parity (UIP) puzzle can be resolved after controlling for liquidity risk and market volatility.

Suggested Citation

  • Erik Schlogl & Yang Chang, 2012. "Carry Trade and Liquidity Risk: Evidence from Forward and Cross-Currency Swap Markets," Research Paper Series 310, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:310

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    References listed on IDEAS

    1. Baba, Naohiko & Packer, Frank, 2009. "From turmoil to crisis: Dislocations in the FX swap market before and after the failure of Lehman Brothers," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1350-1374, December.
    2. Naohiko Baba & Frank Packer & Teppei Nagano, 2008. "The spillover of money market turbulence to FX swap and cross-currency swap markets," BIS Quarterly Review, Bank for International Settlements, March.
    3. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
    4. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2011. "Do Peso Problems Explain the Returns to the Carry Trade?," Review of Financial Studies, Society for Financial Studies, vol. 24(3), pages 853-891.
    5. Lasse Heje Pedersen & Mark Mitchell & Todd Pulvino, 2007. "Slow Moving Capital," American Economic Review, American Economic Association, vol. 97(2), pages 215-220, May.
    6. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    7. Angelo Ranaldo & Paul Söderlind, 2010. "Safe Haven Currencies," Review of Finance, European Finance Association, vol. 14(3), pages 385-407.
    8. Christiansen, Charlotte & Ranaldo, Angelo & Söderlind, Paul, 2011. "The Time-Varying Systematic Risk of Carry Trade Strategies," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 46(04), pages 1107-1125, September.
    9. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
    10. Ingo Fender & Patrick McGuire, 2010. "European banks' US dollar funding pressures," BIS Quarterly Review, Bank for International Settlements, June.
    11. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
    12. Craig Burnside, 2007. "The Forward Premium is Still a Puzzle," NBER Working Papers 13129, National Bureau of Economic Research, Inc.
    13. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking," BIS Quarterly Review, Bank for International Settlements, March.
    14. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
    15. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters,in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
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    Cited by:

    1. Jaroslav Baran & Jiří Witzany, 2017. "Analysing Cross-Currency Basis Spreads," Working Papers 25, European Stability Mechanism.

    More about this item


    uncovered interest rate parity; carry trade; liquidity risk; no-arbitrage bound; volatility;

    JEL classification:

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

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