Measuring liquidity risk effects on carry trades across currencies and regimes

We study the effects of FX liquidity risk on carry trade returns using a novel low-frequency market-wide liquidity measure. We show conclusively that the vast majority of variation in carry trade returns can be explained by two risk factors (liquidity risk and market risk). Our results are further corroborated when the mimicking liquidity risk factor is replaced with a non-tradable innovations risk factor. Safe-haven currencies (SHC) provide insurance against crash risk by having negative liquidity betas, across all time periods. SHCs provide the highest levels of protection during periods of extreme volatility. We find that liquidity risk is priced in the cross-section of carry trade returns, and estimate the liquidity risk premium in the FX market to be around 412 basis points per annum.