In theory, the carry trade, in which investors fund the purchase of high-yielding currencies by selling low-yielding currencies, should not produce consistent returns. That is because, according to uncovered interest-rate parity, exchange rates should move to compensate for the interest-rate differential. However, historically, it has proven to be a profitable trading strategy.
In a paper due to be published in the Journal of Finance, Loriano Mancini, of the Swiss Finance Institute, along with Angelo Ranaldo and Jan Wrampelmeyer, of the University of St Gallen, attempt to unlock the mystery.
Using data from Icap’s EBS electronic platform, the study analyzed liquidity in the FX market. It found that, contrary to common perceptions, FX – as the world’s largest financial market – is highly liquid at all times, and all exchange rates experienced a substantial decline in liquidity during the financial crisis, especially after the bankruptcy of Lehman Brothers.
For the least-liquid exchange rates, the liquidity evaporation was 10 times more severe than for the most liquid.
| Average daily effective spread |
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| Source: Mancini et al, 2012 |
The study found that FX illiquidity was not isolated to certain exchange rates. Instead, market liquidities of individual currencies move together and are positively – to different degrees – related to market-wide FX liquidity.
“This commonality in liquidity implies that FX liquidity is largely driven by shocks affecting the FX market as a whole, rather than by idiosyncratic shocks to the liquidity of individual exchange rates,” states the study.
“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.”
To quantify liquidity risk costs, the study analyzed the effect on an AUDJPY carry trade of a sudden rise in illiquidity. It found that speculators forced to unwind the position in an environment of sudden exchange-rate movements, in conjunction with high bid-ask spreads, lose 13% of their capital – 25% more than in the benchmark case without FX liquidity cost.
Mancini and his colleagues believe carry trade returns can, at least partially, be explained by FX liquidity risk.
They call the link between currency return and liquidity risk “liquidity betas”.
| Liquidity betas and interest rate differentials from the perspective of a US investor |
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| Source: Mancini et al, 2012 |
“Low interest-rate currencies exhibit negative liquidity betas, thus funding currencies offer insurance against liquidity risk,” they say. “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 therefore have implications for carry trade returns.
When FX 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 uncovered interest-rate parity theory.
Therefore, Mancini and his colleagues believe that during the unwinding of carry trades, market-wide FX 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 investors may demand a risk premium for bearing FX liquidity risk,” they say.
For central banks, these findings offer important guidance on how to smooth a currency sell-off associated with an unwinding of carry trades.
The commonality in FX liquidity implies that providing liquidity for a specific exchange rate might have positive spillover effects to other currencies. So a liquidity injection from a central bank with an investment currency could alleviate liquidity strains in other investment currencies, and moderate the sudden appreciation of funding currencies and depreciation of investment currencies.
However, Mancini and his colleagues warn that abundant liquidity might have consequences that might not be welcomed by central banks.
“Overwhelming liquidity in one currency tends to spread to other currencies in general and investment currencies in particular,” they say.
“In risk-taking environments with attractive carry trade opportunities, ample liquidity could bolster speculative trading.”