Competitive entry and endogenous risk in the foreign exchange market

Recent evidence shows that higher trader participation increasesexchange rate volatility. To explore this linkage, we developa dynamic model of endogenous entry of traders subject to heterogenousexpectational errors. Entry of a marginal trader into the markethas two effects: it increases the capacity of the market toabsorb exogenous supply risk, and at the same time it adds noiseand endogenous trading risk. The competitive entry equilibriumis characterized by excessive market entry and excessively volatileprices. A positive tax on entrants can decrease trader participationand volatility while increasing market efficiency.