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The Effect of a Transaction Tax on Exchange Rate Volatility

Markku Lanne and Timo Vesalay

No ECO2005/19, Economics Working Papers from European University Institute

Abstract: We argue that a transaction tax is likely to amplify, not dampen, volatility in the foreign exchange markets. Our argument stems from the decentralized trading practice and the presumable discrepancy between 'informed' and 'uninformed' traders' valuations. Since informed 'traders' 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.

Keywords: Transaction tax; exchange rates; volatility (search for similar items in EconPapers)
JEL-codes: F31 F42 G15 G28 (search for similar items in EconPapers)
Date: 2005
New Economics Papers: this item is included in nep-cba, nep-fin, nep-fmk, nep-ifn, nep-mst and nep-pbe
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Journal Article: The effect of a transaction tax on exchange rate volatility (2010) Downloads
Working Paper: The effect of a transaction tax on exchange rate volatility (2006) Downloads
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