Real exchange rate volatility and international trade: a reexamination of the theory.

• Author: Dellas, Harris

1. Introduction

   One of the issues that have received considerable attention in the comparison of the properties of alternative exchange rate regimes is the effect of exchange rate risk on the volume of trade. It has been argued that the higher volatility of exchange rates witnessed since the adoption of the floating regime in 1973 has led to a decrease in international trade transactions. This is because most trade contracts are not for immediate delivery of goods; and since they are denominated in terms of the currency of either the importer or the exporter, unanticipated fluctuations in the exchange rate affect realized profits and hence the volume of trade. It is implicitly assumed that forward exchange markets that can help traders eliminate this type of variations in profits either are not available (as it is true for the majority of currencies because most are not fully convertible, thereby impairing forward markets) or for some reason they are not utilized to fully hedge exchange risk present in trade transactions.(1)

   The empirical evidence, regarding the effect of exchange rate risk on trade, has at best been inconclusive. The large majority of the empirical studies are unable to establish a systematically significant link between exchange rate variability and the volume of international trade whether on an aggregate or on a bilateral basis. Abrams |1~, Akhtar and Hilton |2~, Cushman |4; 5; 6~ and Kenan and Rodrik |12~ find some significant negative effects of exchange volatility on exports. However, Bailey, Tavlas, and Uhlan |3~, Hooper and Kohlhagen |10~ and an International Monetary Fund Study |11~ do not find any supporting evidence for the depressing effect of exchange rate volatility on international trade. It is also interesting to note that, in many of these studies, a significant positive effect of exchange rate volatility on the volume of trade is found for some cases. However, the positive effect, believed to be at odds with the theory was either ignored or dismissed as a perverse result, since "as far as volumes are concerned, theoretical considerations are unambiguous in suggesting that increased uncertainty should reduce the level of trade" |11, 18~.

   The purpose of this paper is to show that a positive effect of exchange rate variability on trade has a theoretical basis.(2) There can be no theoretical presumption that an increase in exchange risk has an adverse effect on trade. The key to this claim is the fact that nominal unhedged trade contracts are standard risky assets that can be analyzed in a conventional asset portfolio model. Consequently, whether an increase in the riskiness of the return on these assets--that is, an increase in the volatility of the exchange rate--increases or decreases investment (trade), will in general depend on the risk aversion parameter of the model. The existing work on the effects of exchange rate uncertainty on trade has employed, as recognized by Hooper and Kohlhagen |10~ a restrictive version of portfolio choice which leads to an unambiguously negative relation. Our theoretical analysis implies that the empirical evidence, rather than being a puzzle, can be reinterpreted as saying something about attitudes towards risk. Given the widely held presumption that exchange rate volatility is detrimental to the volume of trade, we feel that this paper makes a worthy contribution.

2. The Basic Model

   In this paper we exploit the similarity of trade decisions to the portfolio-savings decisions under uncertainty. The model we employ is one with incomplete asset markets and ex ante trading decisions, in which the choice of exports(3) is made before the resolution of uncertainty in prices. To facilitate the exposition we analyze the behavior of a small open economy, first assuming that no forward exchange markets are available; later we introduce a forward market but we require the payment of a fee (commission) for participation in forward transactions. In both cases we show that increased riskiness affects the volume of trade, but the sign of this effect is ambiguous depending on the risk aversion parameter.

   We employ the standard set up for a small country as in Cushman. Let the domestic country be endowed with some good Y, and the rest of the world be endowed with some different good Z. The representative domestic agent lives for two periods but consumes only in the second period. In the first period, t, she receives her share of output and decides how much...