International trade and exchange rate volatility

rie

e

asmus Universiteit ~~tter~arn, Rotterdam, The Netherlands

t~olieke ~~iversit~it Leuven. B-

lgium

eceived September 1989, final version received

ay 1991

For currencies with well developed forward markets several papers have investigated the conjectured negative relationship between trade and short term exchange rate volatility, without successful. A theoretical planation for the empirical anomalies is provided by icitly for the forward rate. ecause importers and exporters a on opposite sides oreover, which tra market, so is their exposu towards exchange rate volatility. ts and which one loses from increased volatility is determin by the signs of t aggregate net foreign currency exposure and the aggregate measure of risk aversion.

ge rate variability

hshers

on the volume of

1312

Viaene and C.C. de Vries, International

trade and exchange

rate volatility

consideration. In the former case no consistent link between volatility a

tries currencies sometimes not. and for most longer term currency contracts efficient forward markets are absent. In this case there is some unequivocal evidence of a egativ udies do corroborate the theory, is ne respect in whit the convention The aim of the paper is to advance a theoretical explanation for the ationship between the volume of resence of well developed forward

e forward rate, while the hedge

footnote 1 presume a therefore erroneou

t of volatility on exports roper optimization, however, is more

n explicit solution for the e spot rate conditional variance.

and the central that domestica

the returns are: aY - Y2/2, where

is the quantity demanded at price S. The

orter receives trade credit for one

-t(c--f)L-fY2.

(1)

n addition to the above items, one may want to include labor costs, storage costs, etc. ut as long as these ec;?t items are linear or quadratic, eq. (1) is n cted qualitatively. ny agent i is assumed to maximize the following expected utilit function:3

(2) The merchants are assumed to be risk averse, i.e. Q< a, < 00, but speculators - 00 c ai < 0 is allowed for below. rst co (1).

izing c

3

e.

ces

1314

J.-M.

Viaene and C.G. de Vries, International

trade and exchange

rate volatility

Y-a-

Q

L=(E---f )Jcd +

(5

a

> f.

Note that the i

ration theorem, but e exchange rate volatility estic exporters we postu

P=fix+(\bf)

(6

is t hi&. may be production costs y with the derivation of the importer’s cost function, and s&s on wc?rld markets at a price of unity. In the recess, the exporter erefore experiences extends the customary one-period trade credit and uncertainty which may be hedged if there is a forward hedging, the optima

x = (Ef a forwar

d)/( 1 + rid).

oes exist thcr:opti

(7) ge levels are

speculators to take opposite positions vis-a-vis t e net position o merchants (as in the case of the i ut we do allow be risk loving, i.e. ai< 0 is possi s would reverse ants and the s culators, the centra

is an

important actor on t swaps to indulge into modelling its havior explici ere, we consider its rward supply of foreign currency the model. urn forward rate f can now be easily derived from t clearing condition n

i= 1

m

s

Li+

i-F=O,

i+ i=l

i=l

er of importers, ante TB as the

c .m

=

n

1

i =

1

i= 1

Yi*

1316

J.-M. Viaene and C ;. de Vries, International trade and exchange rate volatility

i= 1

i= 1

the risk premium and the trade balance are linear functions of f. ral the risk premium the trade balance, the attit

ds to zero, the risk premiu

m Yixi-

i= 1

i= 1

a7p=-

a

(17)

1 +m2

ave the following result. In the absence of forwa

nge rate affects trade flows and the conventional terms of trade analysis. An increase in exchange rate volatility reduces both imports and exports, and the surplus or deficit of the balance of trade is reduced as well.

is results cmro

1318

J.-M. Viaerr and C.G. de Vries, International trade and exchange rate volatility

at the only channel through or the volatility of the exchan er e forward rate f.

1,. .., m and j= I,..., VI. The effects of changes in the expected rate just corroborate eq. (16) and roposition 1. The striking implication of reposition 2 is, owever, that the effects of a change in volatility on imports iand exports are opposite to each

osition 2. Note tha

ith a forward market’

and

e

conclusions of fropothat is

d in several of

may not be unimportant as can ewe, forward intervention may alter the

ve considered the changes in E

Zerentiate eq. (14) “eoobtain

df

?f : af, a&

; df -Q~2f~r52C 1 +(m+n)Qa” F ao2 F=

l

Consider the special case of a mean preserving spread change, then

Viaene and

C.G.de Vries, international trade and exchange rate volatility

em exchange rate and its

nt and the European Effects on trade and

Papers 32,475512. patterns, Journal of Internit ional Economics 3, 105- 116. Holthausen, D.M., 1979, Hedging and the co petitive firm and price competition, American Economic Review 69,989-995. Ihagen, 1978, The effect of exchange rate uncertainty on the prices and I trade, Journal of I~t~r~atio~al Economics 8,483-511. 1979, The effect of forward markets on exporting firms, Economics Letters 4, 271-274. 1984, The effect of forward exchange on spot-rate volatility under risk and rational awai, ions, Journal of International Economics 16, 155-l 72. expe Kenen, P.B. and D. Rodrik, 1984, Measuring and analyzing the effects of short-term volatility in real exchange rates, Working papers in international economics, G84-Cl1 (International Finance Section, ring and analyzing the effects of short-term volatility in Kenen, P.B. and D. tistics 68, 311-315. real exchange rat Pagan, A., 1984, Econom regressions with generated .egressors, International Economic Review 25, 221-247. Stein, J.L., 1985, Exchange rate management with rational expectations ut diverse precisions, S. Bhandari, ed., Exchange pate management under uncertainty ( IT Press, Cambridge,

eree, 1989, Exchange rate uncertainty and foreign trade, European Economic Review 33, 1241-1264. Thursby, J.G. and M.C. Thursby, 1987, Bilateral trade flows, the Linder hypothesis, and risk, The Review of Economics and Statistics 69, 488-495. and C.G. de Vries, 1992, On the design of invoicing practices in international trade, Open Economies Review, forthcoming.