The Change in FX liquidity: Funding Constraints and Global Risks as Roles of the Change

This paper investigates the measure of FX liquidity and determinants of the change in FX liquidity. Using 20 cross currency exchange rates over spanning period of 1999 to 2016, funding constraints and global risks are responsible for the main drivers of changing in FX liquidity, especially the change in TED spread, repos, and volatility index for both G7 and emerging countries. The magnitudes of both G7 and emerging volatility index are offsetting each other in all the regression models indicating that FX investors take diversification trading strategies to diversify their portfolios. The financial crisis provides an evidence that the more financial constraint issues contribute to the change in FX market illiquidity more than non-financial crisis period. Extending to liquidity predictability, I find, however, that the lag of market FX liquidity is responsible for the change in FX liquidity than any other explanatory variables. I also find that the excess return predictability depends highly on the average variance of currency excess returns more than other variables, including the change in liquidity.