isk caused by huge volatility in financial market can lead investors or speculators into operating with extremely high margins that could eventually compel traders to scale down or totally halt their positions to avoid currency crash; (iv) finally, liquidity risk can lead to a drastic reduction in investor’s expectation for gains, which invariably helps to correct the violation of Uncovered Interest Rate Parity (UIP) normally referred to as “forward premium puzzle” (Brunnermeier and Pedersen, 2009).
In this paper, qualitative research methodology is employed by scrutinizing related literature. Any observable limitations in this study stem from the body of literature consulted in the course of preparing this research, and attempts are made to restrict the subject-matter only to liquidity risk and its effects on carry trade returns.
The financial crisis that has recently hit the global economy has highlighted an important concept that has long been ignored by economists, policymakers and other stakeholders in the industry: the importance of liquidity in the health of financial systems. According to Ben Bernanke, chairman of the Federal Reserve System, the “weak liquidity risk controls were a common source of the problems many firms have faced" (Bernanke, 2008). But it was only after the financial meltdown in 2007-2008 that it was acknowledged and sufficiently recognized by the industry. The financial speculators have long operated with such greed that eventually resulted to the vulnerability of the financial and banking industry with the gigantic risks that have been accumulated, which is unprecedented in modern history (Froot, 2001). The practices of unwinding of investors’ positions, higher liquidity risk, higher margins and the consequent low returns have eventually created the volatility in the financial market.
An investigation on the liquidity issue and its effect on all financial markets are quite comprehensive and so, for this paper, I would be