infonet-economy

We provide the first systematic study of liquidity in the foreign exchange market.
We find significant variation in liquidity across exchange rates, substantial
illiquidity costs, and strong commonality in liquidity across currencies and with
equity and bond markets. We analyze the impact of liquidity risk on carry trades,
a popular trading strategy that borrows in low-yielding currencies and invests in
high-yielding currencies. Results show that funding (investment) currencies offer
insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong
impact on carry trade returns from 2007 to 2009, suggesting that liquidity risk
is priced. We present evidence that liquidity spirals may trigger these findings.