(DP 1988-07) Liquidity, Risk, and Efficient Forward Foreign Exchange Markets

Abstract

In this paper I suggest a partial answer to a question: if forward and spot currency markets are not "efficient" in the sense that on average the speculative profits agents can make in this market given information at the time expectations are formed are nonzero, why are they not so? Research that has suggested the inclusion of risk premia has met with mixed results in empirical tests. This paper suggests that treating currency as having differential liquidity services in a dynamic programming framework provides an alternative model that can accommodate some empirical facts that risk premia along cannot account for.