Introduction

The structure and openness of the international financial markets has significantly changed since 1970. Financial deregulation has led to the internalisation of the financial services industry while the progressive liberalisation of international capital movements has allowed, and has been followed by, large-scale cross-country portfolio diversification. These developments have stimulated the growth of the world foreign exchange markets. In a related study (Arcelli et al., 1990), we described the liberalisation process that occurred in the foreign exchange markets after 1980. The analysis revealed that the size of these markets has increased enormously during this period. One main factor has been the separation between trade-motivated transactions and total transactions in foreign exchange. Most of the turnover in the foreign exchange markets that we analysed was generated by financial operations, and a large part of them were of a speculative nature.

In this chapter, we study whether the growth of the market and the dramatic changes in the type of transactions and traders have had a major impact on exchange rate volatility. In particular, we analyse the relationship between financial innovation, capital liberalisation, transaction volume and exchange rate volatility. First we present, in Section 2, a model of the foreign exchange market which produces a simple relationship between volume of transactions and exchange rate variability. One of the implications of the model is that there exist changes in the structure of financial markets which generate a simultaneous increase in the volume of transactions and of the distribution of exchange rates.