2010-3
Swiss National Bank Working Papers
Liquidity in the Foreign Exchange Market:
Measurement, Commonality, and Risk Premiums
Loriano Mancini, Angelo Ranaldo and Jan Wrampelmeyer
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ISSN 1660-7716 (printed version)
ISSN 1660-7724 (online version)
© 2010 by Swiss National Bank, Börsenstrasse 15, P.O. Box, CH-8022 Zurich
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Liquidity in the Foreign Exchange Market:
Measurement, Commonality, and Risk Premiums
∗
Loriano Mancini
Swiss Finance Institute
and EPFL
†
Angelo Ranaldo
Swiss National Bank
Research Unit
‡
Jan Wrampelmeyer
Swiss Finance Institute
andUniversityofZurich
§
November 20, 2009
Abstract
This paper develops a liquidity measure tailored to the foreign exchange (FX) market, quan-
tifies 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.
Keywords: Foreign Exchange Market, Measuring Liquidity, Commonality in Liquidity
Liquidity Risk Premium, Subprime Crisis
JEL Codes: F31, G01, G12, G15
∗
The authors thank Francis Breedon, Antonio Mele, Lukas Menkhoff, Erwan Morellec,
ˇ
LuboˇsP´astor, Lasse Heje
Pedersen, Ronnie Sadka, Ren´e Stulz, Giorgio Valente, Adrien Verdelhan, Paolo Vitale, and Christian Wiehenkamp as
well as participants of the Warwick Business School FERC 2009 conference on Individual Decision Making, High Fre-
quency Econometrics and Limit Order Book Dynamics, the 2009 European Summer Symposium in Financial Markets,
and the Eighth Swiss Doctoral Workshop in Finance for helpful comments. The views expressed herein are those of
the authors and not necessarily those of the Swiss National Bank, which does not accept any responsibility for the
contents and opinions expressed in this paper. Financial support by the National Centre of Competence in Research
”Financial Valuation and Risk Management” (NCCR FINRISK) is gratefully acknowledged.
†
Loriano Mancini, Swiss Finance Institute at EPFL, Quartier UNIL-Dorigny, Extranef 217, CH-1015 Lausanne,
Switzerland. Phone: +41 21 69 30 107, Email: loriano.mancini@epfl.ch
‡
Angelo Ranaldo, Swiss National Bank, Research Unit, B¨orsenstrasse 15, P.O. Box, CH-8022 Zurich, Switzerland.
Phone: +41 44 63 13 826, Email: angelo.ranaldo@snb.ch
§
Jan Wrampelmeyer, Swiss Banking Institute, University of Zurich, Plattenstrasse 32, 8032 Zurich, Switzerland.
Phone: +41 44 63 44 128, Email: wrampelmeyer@isb.uzh.ch
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1. Introduction
Recent events during the financial crisis of 2007–2009 have highlighted the fact that liquidity is a
crucial yet elusive concept in all financial markets. With unprecedented coordinated efforts, central
banks around the world had to stabilize the financial system by injecting billions of US dollars
to restore liquidity. According to the Federal Reserves’s chairman Ben Bernanke, “weak liquidity
risk controls were a common source of the problems many firms have faced [throughout the crisis]”
(Bernanke, 2008). Therefore, measuring liquidity and evaluating exposure to liquidity risk is of
relevance not only for investors, but also for central bankers, regulators, as well as academics.
While there exists an extensive literature studying the concept of liquidity in equity markets,
liquidity in the foreign exchange (FX) market has mostly been neglected, although the FX market
is by far the world’s largest financial market. The estimated average daily turnover of more than
3.2 trillion US dollar in 2007 (Bank for International Settlements, 2007) corresponds to almost eight
times that of global equity markets (World Federation of Exchanges, 2008). Due to this size, the FX
market is commonly regarded as extremely liquid. Nevertheless, events during the financial crisis
and the recent study on currency crashes by Brunnermeier, Nagel, and Pedersen (2009) highlight
the importance of liquidity in the FX market. Similarly, Burnside (2009) argues that liquidity
frictions potentially play a crucial role in explaining the profitability of carry trades as “liquidity
spirals” (Brunnermeier and Pedersen, 2009) aggravate currency crashes and pose a great risk to
carry traders. Therefore, investors require to be able to carefully monitor FX liquidity as they are
averse to liquidity shocks.
The main contribution of this paper is to develop a liquidity measure particularly tailored to
the FX market, to quantify the amount of commonality in liquidity across different exchange rates,
and to determine the extent of liquidity risk premiums embedded in FX returns. To that end, a
daily return reversal liquidity measure (P´astor and Stambaugh, 2003) accounting for the role of
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contemporaneous order flow in the determination of exchange rates (Evans and Lyons, 2002) is
developed and estimated using a new comprehensive data set including ultra high frequency return
and order flow data for nine major exchange rates. Ranging from January 2007 to December 2008,
the sample covers the financial crisis during which illiquidity played a major role. Thus, this period of
distressed market conditions is highly relevant to analyze liquidity. The proposed liquidity measure
is based on structural microstructure models featuring a dichotomy between the fundamental price
and the observed price. The measure identifies currency pairs and periods of high and low liquidity,
for instance, EUR/USD is found to be the most liquid exchange rate and liquidity of all currency
pairs decreases during the financial crisis.
Testing for commonality in FX liquidity is crucial as sudden shocks to market-wide liquidity
have important implications for regulators as well as investors. Regulators are concerned about the
stability of financial markets, whereas investors worry about the risk–return profile of their asset
allocation. Decomposing liquidity into an idiosyncratic and a common component allows investors
to exploit portfolio theory to reap diversification benefits with respect to liquidity risk. Therefore, a
time-series of systematic FX liquidity is constructed representing the common component in liquidity
across different exchange rates. Empirical results show that liquidity co-moves strongly across cur-
rencies supporting the notion of liquidity being the sum of a common and an exchange rate specific
component. Systematic FX liquidity decreases dramatically during the financial crisis, especially
after the default of Lehman Brothers in September 2008.
The last part of the paper investigates whether investors require a return premium for bearing
liquidity risk. For that reason, a liquidity risk factor is constructed from unexpected shocks to sys-
tematic liquidity. The role of liquidity risk in the cross-section of FX returns is analyzed by extending
a recently developed factor model for excess FX returns (Lustig, Roussanov, and Verdelhan, 2009)
by this novel risk factor. Estimation results suggest that liquidity risk is a heavily priced state vari-
able. Apart from stressing the importance of liquidity risk in the determination of FX returns, this
