EXCHANGE RATE REGIMES, FX LIQUIDITY RISK, AND CARRY TRADE RETURNS

1 online resource (210 pages) : PDF

2016

University of North Carolina at Charlotte

The dissertation consists of three related topics: FX market-wide liquidity measure and individual currency-pair liquidity co-movements, FX liquidity risk and carry trade returns, and the forward premium puzzle in foreign exchange markets. This is the first study to investigate the effects of FX liquidity risk on carry trade returns using a low frequency liquidity measure. I show that liquidity-based ranking of currency pairs can be used to construct a liquidity risk factor, which helps in explaining the variation of carry trade returns across exchange rate regimes. In a liquidity-adjusted asset pricing framework, I show that the vast majority of variation in carry trade returns during any exchange rate regime can be explained by two risk factors (market risk and liquidity risk) in the FX market. I also document the exposure of high and low interest rate currencies to liquidity risk. The results are further corroborated when the hedge liquidity risk factor is replaced with a non-tradable innovations risk factor. This study also contributes to the extant international finance literature by showing that the negative slope coefficients in Fama’s 1984 UIP regressions become positive in low liquidity regimes for high interest rate currencies. This finding helps in explaining the forward premium puzzle in low liquidity regimes. Finally, I document the persistence of the forward premium puzzle for a typical carry trade funding currency (JPY). This lends support to the global usage of the Japanese yen as a funding currency of the carry trade strategy.

doctoral dissertations

Finance
Industrial management
Economics

Ph.D.

Carry Trade Returns
Exchange Rate Regimes
Forward Premium Puzzle
FX Liquidity Risk

Business Administration

Blenman, Lloyd

Tian, Weidong
Chiang, I-Hsuan Ethan
Troyer, Jennifer

Thesis (Ph.D.)--University of North Carolina at Charlotte, 2016.

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