Liquidity being an elusive concept is often difficult to measure, and it becomes even vaguer in currency options market which provides investors an alternative to hedge against foreign exchange fluctuations. Over past few years since the starting of trading of currency options contracts on US dollar-Indian rupee in Indian exchanges began, the currency market has grown significantly. Currency options trades at the National Stock Exchange of India is ranked first among exchanges across the world in terms of volume traded and number of trades, and third in terms of traded value (WFE, 2011). Hence, in this paper, we examine the systematic component of liquidity as source of price changes in the Indian currency options market. Using daily data on trading volume, value, open interest, and spot USD-INR exchange rate from November 2010 to October 2012, we compute the Amihud ratio (Amihud, 2002) as a proxy for market-level illiquidity in the Indian currency options market. Vector error correction model (VECM) estimation approach is employed to examine the causal relationship among illiquidity, volatility, returns and speculation in currency options market. Specifically, we aim to address the following issues with respect to the currency options market for USD-INR: (1) What makes the liquidity in the currency options market suddenly dry up? (2) How is the liquidity in the currency options market related to volatility? and (3) Does speculators' capital drive the currency options market?
