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The Effect of a Transaction Tax on Exchange Rate Volatility

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Author Info
Markku Lanne
Timo Vesalay

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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.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2005/19.

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Date of creation: 2005
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Handle: RePEc:eui:euiwps:eco2005/19

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Related research
Keywords: Transaction tax; exchange rates; volatility;

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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  2. Andersen T. G & Bollerslev T. & Diebold F. X & Labys P., 2001. "The Distribution of Realized Exchange Rate Volatility," Journal of the American Statistical Association, American Statistical Association, vol. 96, pages 42-55, March. [Downloadable!] (restricted)
  3. Gallant, A. Ronald, 1982. "Unbiased determination of production technologies," Journal of Econometrics, Elsevier, vol. 20(2), pages 285-323, November. [Downloadable!] (restricted)
  4. Andersen, Torben G. & Bollerslev, Tim, 1997. "Intraday periodicity and volatility persistence in financial markets," Journal of Empirical Finance, Elsevier, vol. 4(2-3), pages 115-158, June. [Downloadable!] (restricted)
  5. Gallant, A. Ronald, 1981. "On the bias in flexible functional forms and an essentially unbiased form : The fourier flexible form," Journal of Econometrics, Elsevier, vol. 15(2), pages 211-245, February. [Downloadable!] (restricted)
  6. Frank M. Song & Junxi Zhang, 2005. "Securities Transaction Tax and Market Volatility," Economic Journal, Royal Economic Society, vol. 115(506), pages 1103-1120, October. [Downloadable!] (restricted)
  7. James Tobin, 1978. "A Proposal for International Monetary Reform," Cowles Foundation Discussion Papers 506, Cowles Foundation, Yale University. [Downloadable!]
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  8. Torben G. Andersen & Tim Bollerslev, 1998. "Deutsche Mark-Dollar Volatility: Intraday Activity Patterns, Macroeconomic Announcements, and Longer Run Dependencies," Journal of Finance, American Finance Association, vol. 53(1), pages 219-265, 02. [Downloadable!] (restricted)
  9. Danielsson, J. & Payne, R., 2002. "Real trading patterns and prices in spot foreign exchange markets," Journal of International Money and Finance, Elsevier, vol. 21(2), pages 203-222, April. [Downloadable!] (restricted)
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  10. Andersen, Torben G & Bollerslev, Tim, 1998. "Answering the Skeptics: Yes, Standard Volatility Models Do Provide Accurate Forecasts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 885-905, November.
  11. Jones, Charles M & Seguin, Paul J, 1997. "Transaction Costs and Price Volatility: Evidence from Commission Deregulation," American Economic Review, American Economic Association, vol. 87(4), pages 728-37, September. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Jokipii, Terhi, 2006. "Forecasting market crashes: further international evidence," Research Discussion Papers 22/2006, Bank of Finland. [Downloadable!]
  2. Ravenna , Federico & Seppälä , Juha, 2006. "Monetary policy and rejections of the expectations hypothesis," Research Discussion Papers 25/2006, Bank of Finland. [Downloadable!]
  3. Anandarajan , Asokan & Hasan , Iftekhar & McCarthy , Cornelia, 2006. "The use of loan loss provisions for capital management, earnings management and signalling by Australian banks," Research Discussion Papers 23/2006, Bank of Finland. [Downloadable!]
  4. Marsh , Ian W, 2006. "The effect of lenders’ credit risk transfer activities on borrowing firms’ equity returns," Research Discussion Papers 31/2006, Bank of Finland. [Downloadable!]
  5. Jokivuolle , Esa & Peura , Samu, 2006. "Rating targeting and the confidence levels implicit in bank capital," Research Discussion Papers 27/2006, Bank of Finland. [Downloadable!]
  6. Välimäki , Tuomas, 2006. "Why the marginal MRO rate exceeds the ECB policy rate?," Research Discussion Papers 20/2006, Bank of Finland. [Downloadable!]
  7. Kilponen , Juha & Kinnunen , Helvi & Ripatti , Antti, 2006. "Population ageing in a small open economy – some policy experiments with a tractable general equilibrium model," Research Discussion Papers 28/2006, Bank of Finland. [Downloadable!]
  8. Aalto-Setälä , Ville & Schindler, Robert, 2006. "The importance of attractive prices in pricing dynamics," Research Discussion Papers 30/2006, Bank of Finland. [Downloadable!]
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