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The Effect of a Transaction Tax on Exchange Rate Volatility

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  • Markku Lanne
  • Timo Vesalay

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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Bibliographic Info

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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Keywords: Transaction tax; exchange rates; volatility;

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  15. 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.
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Cited by:
  1. Olivier Damette, 2009. "Exchange rate volatility and noise traders: Currency Transaction Tax as an eviction device," Economics Bulletin, AccessEcon, vol. 29(3), pages 2449-2464.
  2. Olivier Damette, 2013. "Mixture distribution hypothesis and the impact of a Tobin tax on exhange rate volatility : a reassessment," Working Papers of BETA 2013-07, Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg.
  3. Danuse Nerudova, 2011. "Taxing the financial sector in the European Union," MENDELU Working Papers in Business and Economics 2011-16, Mendel University in Brno, Faculty of Business and Economics.
  4. Francis Bismans & Olivier Damette, 2012. "La taxe Tobin : une synthèse des travaux basés sur la théorie des jeux et l’économétrie," Working Papers of BETA 2012-09, Bureau d'Economie Théorique et Appliquée, UDS, Strasbourg.

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