Liquidity in the Foreign Exchange Market: Measurement, Commonality, and Risk Premiums

Abstract

A daily return reversal measure of liquidity is developed and estimated using a new comprehensive ultra-high frequency data set of foreign exchange rates during the financial crisis period of

When do low-frequency measures really measure transaction costs?

“…Similar to the estimation of mean of daily equity returns, recovering liquidity measures-which are small, positive-valued quantities-from noisy transaction data is challenging. For highly liquid assets, using high-frequency transactions data is probably the only reasonable way for estimation of accurate liquidity measures; see Chordia, Sarkar, and Subrahmanyam (2005) and Mancini, Ranaldo, and Wrampelmeyer (2013). If one must use a low-frequency measure, then as we show in this study, for less liquid assets the consistent version of Corwin and Schultz (2012) performs better than other competing measures, provided that one uses a fairly long window of data (at least one year) for constructing the measure.…”

“…With the increasing availability of high-frequency data since the 1990s, one strand emphasizes the importance of using transactions data to calculate trading costs. Chordia, Sarkar, and Subrahmanyam (2005) who study stock and bond market liquidity and Mancini, Ranaldo, and Wrampelmeyer (2013) who examine foreign exchange market liquidity are examples of papers that use high-frequency measures. The other strand argues that the availability of long histories of daily data-dating back to early 1900s-and the significant cost associated with acquiring and processing high-frequency data makes it desirable to estimate transaction costs from low-frequency, daily data.…”

“…Our findings about the upward bias of the low-frequency measures raise questions about their suitability for optimal portfolio choice problems with transaction costs, where the so-called no-trade region is a function of the level of transaction costs (Constantinides, 1986), and for evaluation of trading strategies and asset pricing anomalies, where small changes in transaction costs have a large impact on performance (Novy-Marx and Velikov, 2015, Chen and Velikov, 2018, and Patton and Weller, 2018. The dependence of the lowfrequency measures on volatility limits their use in studies of the commonality in liquidity, where liquidity proxies are used to measure co-movements in liquidity across assets and markets (Chordia, Roll, and Subrahmanyam, 2000, Hasbrouck and Seppi, 2001, Korajczyk and Sadka, 2008, Karolyi, Lee, and Van Dijk, 2012, Mancini, Ranaldo, and Wrampelmeyer, 2013. In all of these applications, using imperfect proxies for transaction costs can lead to suboptimal financial decisions.…”

Is Liquidity Risk Priced in Partially Segmented Markets?

“…Amihud (2002)'s widely applied price impact measure has been recently used in Karolyi et al (2012) to analyze the commonality patterns of liquidity, returns, and turnover across 40 countries. Korajczyk and Sadka (2008), Mancini, Ranaldo, and Wrampelmeyer (2013) and Kim and Lee (2014) use a latent liquidity measure constructed from a principal component across different liquidity measures. See also Fong, Holden, and Trzcinka (2014) for a recent review of the different liquidity proxies used in international studies.…”

Can Cash Flow Expectations Explain Momentum and Reversal?

“…Beber, Breedon, and Buraschi (2010) note that the yen-dollar carry trade performs poorly when dierences of opinion are high. Mancini, Ranaldo, and Wrampelmeyer (2013) nd that systematic variation in liquidity in the foreign exchange market contributes to the returns to the carry trade. Bakshi and Panayotov (2013) include commodity returns as well as foreign exchange volatility and liquidity in their risk factors.…”