Changes in FX liquidity: Roles of Funding Constraints and Global Risks

Abstract

This paper investigates the measure of FX liquidity and determinants of the change in FX liquidity. Using 20 cross currency exchange rates over the spanning period of 1999 to 2016, we find that funding constraints and global risks are responsible for the change in FX liquidity. The magnitudes of both G7 and emerging volatility index are offsetting each other in all the regression models indicating that FX investors take diversification trading strategies to diversify their portfolios. The financial crisis provides evidence that the more financial constraint issues contribute to the change in FX market liquidity more than non-financial crisis period. Extending to return predictability, we find that the average variance contributes the most for currency predictability more than other explanatory variables.