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Global Liquidity Risk in the Foreign Exchange Market

by: Chiara Banti, Kate Phylaktis, Lucio Sarno
Journal of International Money and Finance (November 2011), doi:10.1016/j.jimonfin.2011.11.010  Key: citeulike:10047765

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Abstract

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analogue of the well-known Pastor-Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.


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