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AbstractUsing a broad data set of 20 US dollar exchange rates and order ‡ow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analogue of the well-known Pastor-Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.
The paper investigates the impact of global liquidity on house prices around the world using a novel proxy measured by the funding availability to global banks in the main financial centers. We find supporting evidence that global conditions from the financial centers are transmitted to local banks through bank flows. Focusing on the repo markets in the US, Europe, and the UK, over the period 2000-2014 and using a panel VAR, we find that liquidity shocks impact house prices in both emerging and advanced economies. However, countries' exposure to liquidity shocks can be mitigated by monetary policy, and by various general and house market specific macroprudential policies. We document strikingly different effectiveness of these policies in advanced and emerging markets.
We study various aspects of the impact of funding liquidity constraints and capital flows, which proxy for supply and demand considerations of liquidity respectively, on two measures of the common component of FX market liquidity across developed and emerging market currencies, transaction costs and market depth. Funding liquidity constraints reduce FX market liquidity, after controlling for global volatility, and have a stronger impact when the amount outstanding of repos is associated with an increase in the costs of funding and a shortening of their maturity. Increasing capital flows at the global level increase liquidity. Demand and supply determinants of liquidity have also a stronger impact during the recent financial crisis, when liquidity dry-ups were severe. The analysis on individual currencies with diverse riskiness confirms that a shock to speculator capital would lead to a reduction in market liquidity through a spiral effect that is stronger for more volatile currencies. Furthermore, more volatile currencies have a stronger exposure to the liquidity effect of capital flows.
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