Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 11/2006:
The effect of a transaction tax on exchange rate volatility

Markku Lanne () and Timo Vesala

Abstract: We argue that a transaction tax is likely to amplify, not dampen, volatility in the foreign exchange mar-kets. Our argument stems from the decentralised trading practice and the presumable discrepancy be-tween ‘informed’ and ‘uninformed’ traders’ valuations. Since informed traders’ valuations are likely to be less dispersed, a transaction tax penalises informed trades disproportionately, leading to increased volatil-ity. 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 transac-tion costs is found to have a significant positive effect on volatility.

Keywords: transaction tax; exchange rates; volatility; (follow links to similar papers)

JEL-Codes: F31; F42; G15; G28; (follow links to similar papers)

25 pages, October 10, 2006

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