Abstract
The foreign exchange (FX) market is commonly regarded as the most liquid financial market. However, the degree of liquidity, i.e. the extent to which trades can be executed rapidly with low transaction costs and little impact on prices, can vary substantially across currencies and over time. In contrast to major currency pairs like EUR/USD, GBP/USD and USD/JPY, the EUR/NOK market is relatively small. Lack of liquidity can therefore have a significant impact on prices, making investors more exposed to substantial losses on their foreign investments. This became especially evident in the wake of Lehman’s failure towards the end of 2008 when many investors simultaneously tried to unwind their long NOK positions. Liquidity conditions deteriorated radically and the krone depreciated by approximately 25 per cent versus the euro over the next three months. We have also seen similar patterns in other episodes of stress in the financial markets.