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...

We study the effects of FX liquidity risk on carry trade returns using a low-frequency market-wide liquidity measure. We show that a liquidity-based ranking of currency pairs can be used to construct a mimicking liquidity risk factor, which helps in explaining the variation of carry trade...