Transactions Costs in the Foreign Exchange Market

One issue in the argument about the merits of pegged and floating exchange rates involves the magnitude of transactions costs in the foreign exchange market under alternative exchange rate regimes. The higher the transactions costs, the greater the deterrence to international trade. Moreover, the higher these costs, the greater the scope for national monetary independence, and more fully the monetary authority in one country could follow policies that might cause the rates of return on assets denominated in its currency to di‹er from rates of return on comparable assets denominated in other currencies, for any given impact in inducing flows of short-term capital. In contrast, the lower the transactions costs in the foreign exchange market, the more the case for national monetary independence must rest on other deterrents to the shifts of funds among national financial centers, such as uncertainty about changes in exchange rates. Transactions costs in the foreign exchange market are not explicit, as in the markets with stan- dardized commissions like the home real estate market and organized security and commodity exchanges. Instead, transactions costs are implicit, as in the over-the-counter security market, and are collected by broker-dealers, primarily the large commercial banks, in the spreads between the prices at which they buy and sell foreign exchange. The transactions costs in the foreign exchange market may di‹er by the pair of currencies involved, by the size of the transaction, by the customer buying the foreign exchange, by the bank selling the foreign exchange, and even by the center in which a particular transaction such as the purchase of dollars with sterling occurs. However, from the point of view providing insights about the scope for monetary independence, the key consider- ation is the estimate of transactions costs incurred by those who pay the lowest costs – the banks in their transactions with each other. The next section discusses previous approaches to the measurement of transactions costs in the foreign exchange market. Then a new approach to estimate the transactions costs using futures prices is presented.