The Role of Transaction Costs for Financial Volatility: Evidence from the Paris Bourse

This paper analyzes the causal linkage between transaction costs and financial volatility under two methodological improvements over the existingliterature. First, we use panel data in which exogenous transaction cost differences in the French stock market are induced by price level dependentminimum price variation rules (tick size rules). Unlike in previous studies based on one-time regulatory tick size changes (like the U.S.decimalization), we can separately identify and control for marketwide volatility changes. Second, we avoid the pitfalls of biased volatilitymeasurement across regimes by using the range as a tick size robust volatility metric. Panel regressions controlling for marketwide volatilityeffects show at high levels of statistical significance that the hourly range volatility of individual stocks increases by more than 30% for a 20%exogenous increase in transaction costs due to tick size variations in the French trading system. In the light of this evidence, higher transactioncosts in general, and security transaction taxes in particular, should be considered as volatility increasing.(JEL: F3, G1, G14) Copyright (c) 2006 by the European Economic Association.