Liquidation Risk: Evidence on Non-Linearities in Uncovered Interest Parity

Abstract

Prospective shocks that force the immediate liquidation of securities to raise liquidity determine the ex-ante excess returns on currencies – a liquidation premium to compensate the investor for their liquidation risk even if they have forward cover. This liquidation premium behaves non-linearly, as postulated by the liquidity-risk augmented uncovered interest rate parity theory. The success of uncovered interest parity is, thus, conditional on the severity of the shock and the levels of interest rates. We examine the empirical validity of these non-linearity propositions using data on five major currencies, and document that the failure of uncovered interest parity is more pronounced when liquidity shocks are more severe and interest rate levels are higher.