Abstract
Legal and institutional changes are making it easier to adjust foreign exchange portfolios. This has raised fears that exchange rates will become increasingly volatile. This paper presents an optimizing, equilibrium model where varying degrees of portfolio substitutability are possible. Our results suggest that if preferences are nearly log linear, or transactions costs are small, exchange rate volatility rises as portfolios become more substitutable. With empirically reasonable parameter values, however, volatility is little affected by substitutability. An implication is that a transactions tax on foreign exchange trading would have little impact.
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