Liquidity and Exchange Rates: An Empirical Investigation.

The article investigates the role of the liquidity yield—or convenience yield—on government bonds in explaining nominal exchange rate movements across the G10 currencies. Using a two-country New Keynesian model augmented with liquidity returns, the study finds that changes in the relative liquidity yield significantly influence exchange rates alongside traditional fundamentals like interest rate differentials and real exchange rate adjustments. Empirical analysis employing panel regressions with monthly data from 1999 to 2018 demonstrates that the liquidity yield effect is robust across countries, not limited to the US dollar or crisis periods, and remains significant after controlling for sovereign default risk and currency swap market frictions. The model also shows improved out-of-sample exchange rate forecasts compared to random walk benchmarks, highlighting the liquidity yield as a crucial and previously underappreciated factor in exchange rate determination.