The beneficial aspect of FX volatility for market liquidity

A substantial body of existing research suggests that asset price volatility is harmful to market liquidity. This paper explores a contrarian view that, by creating opportunities for profit making, exchange rate volatility can be beneficial to trading activity. Utilising granular data from the Thai foreign exchange (FX) market from January 2010 to March 2016, we find that the volatility of the US dollar-Thai baht exchange rate has significant positive effects on trading volume in the spot market, except at very high levels of volatility. We also observe significant heterogeneity in such effects across different types of market participant. In particular, FX volatility has positive effects on the FX trading activity of foreign and interbank players, but it negatively affects that of local players. These results are robust when we control for potential confounding variables, such as information arrivals, that can generate a positive but non-causal co-movement between volatility and volume.

JEL classification: F31, G12

Keywords: asset price volatility, foreign exchange market, investor type, market liquidity, nonlinear effect