Foreign exchange risk: How a liquidity facility could help
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Create account Login Subscribe. Understanding foreign exchange markets is key to understanding the global financial system. Yet, a clear understanding of why and how foreign exchange illiquidity materialises is still missing. This column suggests that foreign exchange liquidity can be impaired in times of flight to quality and higher global risk, and that commonality increases in distressed markets.
Foreign exchange liquidity liquidity is an important feature for all financial markets e. PWCyet relatively little is known about the liquidity of the foreign exchange market. A clear understanding of why and how foreign exchange illiquidity materialises is still missing. For instance, we do not know the fundamental sources driving foreign exchange liquidity and comovements in liquidity of individual currencies the foreign exchange liquidity commonality in market liquidity.
In a recent paper Karnaukh et al. We first identify accurate measures of foreign exchange liquidity exchange liquidity, and then uncover which factors explain the time-series and cross-sectional variation of foreign exchange liquidity.
Our paper contributes to the international finance literature in three ways. First, we provide a methodological contribution to the measurement of foreign exchange liquidity using daily and readily available data. Second, to date foreign exchange liquidity has foreign exchange liquidity comprehensively analysed only over short periods e.
Thus, it has foreign exchange liquidity difficult to explain the significant temporal and cross-sectional variation in currency liquidity. Third, our study sheds light on the determinants of commonality in foreign exchange liquidity.
Some clear results emerge from our study. First, foreign exchange liquidity can be measured accurately using low-frequency daily data that are readily available. To support future research on this area, we made publicly available our data and detailed information to compute foreign exchange liquidity using low-frequency data. Figure 1 shows the patterns of foreign exchange liquidity around four representative events: For each event, the effective trading cost is estimated for two groups foreign exchange liquidity currencies: The first two events are representative examples of deteriorating market conditions, while the third and fourth events might be considered more genuine shocks to the demand and supply of foreign exchange liquidity.
This simple event study shows that foreign exchange liquidity is impaired during crisis episodes. It also suggests that foreign exchange liquidity reacts to seemingly exogenous shocks to demand and supply of liquidity, consistent with supply-side foreign exchange liquidity as postulated by recent theoretical models e.
Vayanos and GrombBrunnermeier and Pedersen and the previous literature focusing on specific episodes of demand pressure e. Our regression analysis extends these results, showing that these effects are even stronger for developed currencies and foreign exchange rates bearing larger exposure to risk factors, such as those representing the investment leg of a classical carry trade foreign exchange liquidity. What are the main implications for policymakers and market participants?
We think that our results highlight at least two dark sides of foreign exchange foreign exchange liquidity. Also, commonality in foreign exchange liquidity is stronger for more-developed currencies with better credit ratings.
For policymakers, these results point to another dark side of foreign exchange liquidity — some institutional features, typically highly praised ones, such as financial integration and openness, may expose currencies to global liquidity shocks.
The sterling-dollar rate in the s. Stefan Gerlach, Peter Kugler. How do Japanese exporters manage their exchange rate exposure? The clearinghouse that saved foreign exchange trading from the crisis. An in-depth understanding of foreign exchange liquidity is important for at foreign exchange liquidity three reasons: First, the foreign exchange market is the world's largest financial market with a daily average trading volume of more than five trillion US dollars in ; Second, the foreign exchange market is crucial in guaranteeing efficiency and arbitrage conditions in many other markets, including bonds, stocks, and derivatives; Third, the foreign exchange market has unique characteristics, so foreign exchange liquidity patterns may differ from those of other asset markets.
Implications What are the main implications for policymakers and market participants? We think that our results highlight at least two dark sides of foreign exchange liquidity: First, they suggest a new dimension of risk foreign exchange liquidity effects, that is, foreign exchange liquidity can be impaired in times of flight to quality and higher global risk. PhD student in Finance, University of St. Professor of Finance, University of St.
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