Examining Global Liquidity Risk in FX Markets: Pricing and Geopolitical Influences

Abstract

This paper examines the role of global liquidity risk and whether it is priced in the foreign exchange market employing data spanning 2012-2025. To further contribute to the literature we extend by investigating the relationship between geopolitical risk and the global FX liquidity conditions. Building on the framework of Banti, Phylaktis and Sarno (2012), we construct currency-level and global liquidity measures using a trading pressure proxy derived from daily price data. We find strong evidence of commonality in liquidity across currencies, and portfolio sorts reveal a monotonic pattern in average excess returns, consistent with a risk based interpretation, however, Fama-MacBeth cross-sectional pricing tests yield no statistically significant liquidity risk premium. The findings suggest that while liquidity remains a systematic feature of FX markets, formal pricing is difficult to establish empirically under modern market conditions. In the second part of the analysis we utilize the constructed measure of global liquidity innovations from the preceding methodology and estimate the relationship between geopolitical risk and FX liquidity. We find a positive significant relationship between geopolitical risk and the measure of global FX liquidity innovations, with the “Acts” sub-index being dominant in explanatory power.