The effect of a transaction tax on exchange rate volatility

Markku Lanne and Timo Vesala
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Timo Vesala : RUESG/Department of Economics, University of Helsinki, Postal: P.O.Box 17, FIN-00014, Finland

No 11/2006, Research Discussion Papers from Bank of Finland

Abstract: We argue that a transaction tax is likely to amplify, not dampen, volatility in the foreign exchange mar-kets. Our argument stems from the decentralised trading practice and the presumable discrepancy be-tween ‘informed’ and ‘uninformed’ traders’ valuations. Since informed traders’ valuations are likely to be less dispersed, a transaction tax penalises informed trades disproportionately, leading to increased volatil-ity. Empirical support for this prediction is found by investigating the effect of transaction costs on the volatility of DEM/USD and JPY/USD returns. High-frequency data are used and an increase in transac-tion costs is found to have a significant positive effect on volatility.

Keywords: transaction tax; exchange rates; volatility (search for similar items in EconPapers)
JEL-codes: F31 F42 G15 G28 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fin, nep-fmk, nep-ifn, nep-mst and nep-pbe
Date: 2006-10-10
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Related works:
Working Paper: The Effect of a Transaction Tax on Exchange Rate Volatility (2005)
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