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The effect of a transaction tax on exchange rate volatility

✍ Scribed by Markku Lanne; Timo Vesala

Publisher: John Wiley and Sons
Year: 2009
Tongue: English
Weight: 139 KB
Volume: 15
Category: Article
ISSN: 1076-9307
DOI: 10.1002/ijfe.399

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✦ Synopsis

Abstract

We argue that a transaction tax is likely to amplify, not dampen, volatility in foreign exchange markets. Our argument stems from the decentralized trading practice and the presumable discrepancy between ‘informed’ and ‘uninformed’ traders' valuations. Given that the informed 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. Copyright © 2009 John Wiley & Sons, Ltd.

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