Competitive Entry and Endogenous Risk in the Foreign Exchange Market

Harald Hau

56 citations0/0 files storedReview of Financial Studies

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Financial Markets and Investment Strategies Financial Risk and Volatility Modeling Economic theories and models

Abstract

Recent evidence shows that higher trader participation increases exchange rate volatility. To explore this linkage, we develop a dynamic model of endogenous entry of traders subject to heterogenous expectational errors. Entry of a marginal trader into the market has two effects: it increases the capacity of the market to absorb exogenous supply risk, and at the same time it adds noise and endogenous trading risk. The competitive entry equilibrium is characterized by excessive market entry and excessively volatile prices. A positive tax on entrants can decrease trader participation and volatility while increasing market efficiency.

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References

2007Brownian Motion and Stochastic Calculus 1990Noise Trader Risk in Financial Markets 1987A Simple Model of Capital Market Equilibrium with Incomplete Information 1993Differences of Opinion Make a Horse Race 1988Brownian Motion and Stochastic Calculus 1995Differential Interpretation of Public Signals and Trade in Speculative Markets 1996The Case for Flexible Exchange Rates 1994A Model of Competitive Stock Trading Volume

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2011The Tobin Tax: A Review of the Evidence 2016The impact of the French securities transaction tax on market liquidity and volatility 2005Information vs. Entry Costs: What Explains U.S. Stock Market Evolution?2010Forecasting exchange rates: The multi-state Markov-switching model with smoothing 2009The tradeoff between risk sharing and information production in financial markets 2013The Impact of the French Securities Transaction Tax on Market Liquidity and Volatility

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