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





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    • Loriano Mancini is at EPFL and the Swiss Finance Institute. Angelo Ranaldo and Jan Wrampelmeyer are at the Swiss Institute of Banking and Finance, University of St. Gallen. The authors thank Campbell Harvey (the Editor), the Associate Editor, two anonymous referees, Viral Acharya, Francis Breedon, Michael Brennan, Pierre Collin-Dufresne, Rüdiger Fahlenbrach, Amit Goyal, Robert Hodrick, Antonio Mele, Lukas Menkhoff, Erwan Morellec, Ľuboš Pástor, Lasse Pedersen, Ronnie Sadka, René Stulz, Giorgio Valente, Adrien Verdelhan, Paolo Vitale, Christian Wiehenkamp, our discussants Alessandro Beber, Tarun Chordia, and Lucio Sarno, as well as participants at the 2012 American Economic Association meetings in Chicago, the 2010 Workshop on International Asset Pricing at the University of Leicester, the 2010 Eastern Finance Association Annual Meeting, the 2010 Midwest Finance Association Annual Meeting, the Warwick Business School FERC 2009 conference on Individual Decision Making, High Frequency Econometrics and Limit Order Book Dynamics, the 2009 CEPR/Study Center Gerzensee European Summer Symposium in Financial Markets, and the Eighth Swiss Doctoral Workshop in Finance for helpful comments. Financial support by the Swiss National Science Foundation—National Centre of Competence in Research “Financial Valuation and Risk Management”—is gratefully acknowledged.


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. Analyzing the impact of liquidity risk on carry trades, we 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.