The effect of a transaction tax on exchange rate volatility

Markku Lanne and Timo Vesala
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Timo Vesala: Tapiola Insurance, Finland, Postal: Tapiola Insurance, Finland

International Journal of Finance & Economics, 2010, vol. 15, issue 2, 123-133

Abstract: We argue that a transaction tax is likely to amplify, not dampen, volatility in foreign exchange markets. Our argument stems from the decentralized trading practice and the presumable discrepancy between 'informed' and 'uninformed' traders' valuations. Given that the informed valuations are likely to be less dispersed, a transaction tax penalizes informed trades disproportionately, leading to increased volatility. 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 transaction costs is found to have a significant positive effect on volatility. Copyright © 2009 John Wiley & Sons, Ltd.

Date: 2010
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Working Paper: The Effect of a Transaction Tax on Exchange Rate Volatility (2005)
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DOI: 10.1002/ijfe.399

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