Liquidity risks drive foreign exchange rates, impacting global currency returns significantly.
The study analyzed Forex trading data to understand how risks related to lack of liquidity affect exchange rates. The researchers found that liquidity risk is important in determining foreign exchange risk premia. For many currencies, exposure to liquidity risk is more significant than traditional carry and momentum risk factors. Variations in the price of liquidity risk contribute significantly to individual currency returns, explaining about 34% of the variability in returns compared to 8% from carry and momentum risk prices.