06.09.2012 Seite 1 / 5 The Foreign Exchange Market Not As Liquid As You May Think September 6 2012 1 23 AM GMT By Loriano Mancini Angelo Ranaldo and Jan Wrampelmeyer The foreign exchange market facilitates international trade and investment and is central to the global financial system Market participants both public and private commonly think of the foreign exchange market as highly liquid at all times This column challenges this view by documenting significant declines in liquidity during the recent financial crisis With an estimated average daily trading volume of 4 trillion the foreign exchange Forex market is by far the world s largest market Bank for International Settlements 2010 Due to this size market participants commonly regard foreign exchange as highly liquid at all times liquid in the sense that you can buy or sell very large sums quickly and without turning the price against yourself by much In a recent study we challenge this view by documenting significant declines in Forex liquidity during the 2007 2009 financial crisis Moreover Forex liquidity risk impairs investors international diversification and affects the returns of popular Forex trading strategies such as carry trades Mancini et al 2012 Follow us Using a novel and comprehensive dataset of intraday data from Electronic Broking Services EBS the leading platform for spot Forex interdealer trading we estimate various liquidity measures capturing different dimensions of market liquidity An asset is considered liquid if it can be sold quickly at low cost without causing a significant price change We investigate price impact trading costs and price dispersion of exchange rates finding significant temporal and cross sectional variation in Forex liquidities Contrary to common perceptions all exchange rates experienced a significant decline in liquidity during the financial crisis especially after the bankruptcy of Lehman Brothers For the least liquid exchange rates the liquidity evaporation was ten times more severe than for the most liquid ones see the comparison of effective bid ask spreads between AUD USD and EUR USD in Figure 1 Figure 1 Average daily effective spread
06.09.2012 Seite 2 / 5 Forex illiquidity is not isolated to certain exchange rates Market liquidities of individual currencies move together and are positively but to different degrees related to market wide Forex liquidity This commonality in liquidity implies that Forex liquidity is largely driven by shocks affecting the Forex market as whole rather than by idiosyncratic shocks to the liquidity of individual exchange rates Forex market liquidity is in turn tied to market wide liquidity of other asset classes such as equities and bonds highlighting that liquidity shocks are a cross market phenomenon What do these results mean for a foreign exchange investor in practice To quantify illiquidity costs we develop an example of a speculator who engages in the AUD JPY carry trade i e she borrows in low yielding Japanese yen and invests in high yielding Australian dollars She is forced to unwind her position when markets are illiquid for instance because she is not able to roll over short term positions In a realistic scenario of sudden exchange rate movements in conjunction with high bid ask spreads we show that the speculator loses 13 of her capital 25 more than in the benchmark case without Forex liquidity cost Thus losses due to Forex illiquidity can be substantial Forex illiquidity does not only affect speculators but every investor or company that owns assets denominated in foreign currencies Even worse commonality in Forex liquidity implies that the phenomenon of diminishing liquidity and the corresponding Forex illiquidity cost affect all exchange rates and thus Forex liquidity risks cannot be diversified away easily The commonality in market wide liquidity of foreign exchange equity and bond markets suggests that liquidity risk impairs the efficacy of international and cross asset class diversification Even a broadly diversified portfolio across asset classes is likely to suffer liquidity issues in crisis periods when market wide liquidities of different asset classes deteriorate contemporaneously Liquidity risk in the foreign exchange market also helps explaining the profitability of carry trades a long standing conundrum in the field of finance According to Uncovered Interest rate Parity UIP the expected carry trade return is zero because exchange rates move to compensate for the interest rate differential Historically however carry trades have yielded an annual return of more than 5 Burnside et al 2011 Previous studies have identified the volatility of global equity markets Lustig et al 2011 or the volatility of Forex markets Menkhoff et al 2012 as risk factors driving carry trade returns We find that carry trade returns can at least partially be explained by Forex liquidity risk We call the link between currency return and liquidity risk liquidity betas As shown in Figure 2 low interest rate
06.09.2012 Seite 3 / 5 currencies exhibit negative liquidity betas thus funding currencies offer insurance against liquidity risk On the other hand liquidity betas for high interest rate currencies are positive hence investment currencies provide exposure to liquidity risk The opposite signs of liquidity betas of high and low interest rate currencies have important implications for carry trade returns When Forex liquidity improves high interest rate currencies appreciate further because of positive liquidity betas while low interest rate currencies depreciate further because of negative liquidity betas increasing the deviation from UIP During the unwinding of carry trades i e when investors sell high interest rate currencies and buy low interest rate currencies market wide Forex liquidity drops and liquidity betas lead to further selling pressure on investment currencies which exacerbates currency crashes This finding is consistent with a flight to liquidity and suggests that investors may demand a risk premium for bearing Forex liquidity risk Liquidity spirals may trigger our findings of declining Forex liquidity commonality in Forex liquidity and liquidity risk premiums in Forex returns see Brunnermeier and Pedersen 2009 The theory of liquidity spirals implies that traders are forced to liquidate positions when funding liquidity diminishes This selling pressure reduces market wide liquidity and triggers large price drops We provide evidence that when traders funding liquidity decreases market wide Forex liquidity drops which then affects exchange rates via their liquidity betas Figure 3 illustrates the time series evolution of our index of illiquidity in the Forex market the TED spread as well as the VIX volatility index highlighting the connection between investors uncertainty and fear proxied by the VIX funding strains proxied by the TED spread and Forex market liquidity Figure 3 Uncertainty in the market funding strains and Forex market illiquidity
06.09.2012 Seite 4 / 5 Several policy implications can be drawn from our study From a central bank perspective commonality in Forex liquidity implies that providing liquidity for a specific exchange rate may have positive spillover effects to other currencies Take the example of investment currencies during an unwinding of carry trades A central banks liquidity injection in its own currency could alleviate liquidity strains in other investment currencies and moderate the sudden appreciation depreciation of funding investment currencies Moreover our empirical evidence on liquidity spirals suggests that monetary policies aimed at relieving funding market constraints could also improve Forex market liquidity in all exchange rates But abundant liquidity may have adverse consequences Overwhelming liquidity in one currency tends to spread to other currencies in general and investment currencies in particular In risk taking environments with attractive carry trade opportunities ample liquidity could bolster speculative trading References Bank for International Settlements 2010 Foreign exchange and derivatives market activity in April 2010 Triennial Central Bank Survey Brunnermeier Markus and Lasse Pedersen 2009 Market liquidity and funding liquidity Review of Financial Studies 22 6 2201 2238 Burnside Craig Martin Eichenbaum Isaac Kleshchelski and Sergio Rebelo 2011 Do peso problems explain the returns to the carry trade Review of Financial Studies 24 3 853 891 Lustig Hanno Nikolai Roussanov and Adrien Verdelhan 2011 Common risk factors in currency markets Review of Financial Studies 24 11 3731 3777 Mancini Loriano Angelo Ranaldo and Jan Wrampelmeyer 2012 Liquidity in the foreign exchange market measurement commonality and risk premiums Journal of Finance forthcoming Menkhoff Lukas Lucio Sarno Maik Schmeling and Andreas Schrimpf 2012 Carry trades and global foreign exchange volatility Journal of Finance 67 2 681 718 Loriano Mancini is Assistant Professor of Finance at the Swiss Finance Institute at EPFL Angelo Ranaldo is Full Professor of Finance and Systematic Risk at the University of St Gallen and Jan Wrampelmeyer is Assistant Professor of
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