THE EFFECTS OF REAL EXCHANGE RATE RISK ON INTERNATIONAL TRADE

1. THE EFFECTS OF REAL EXCHANGE RATE RISK ON INTERNATIONAL TRADE By David O. CUSHMAN Published on Journal of International Economics, 1983 Vol 15

2. Why introduce this article? The first one successfully revealed the negative relationship between the volatility of exchange rate and the trade volume The longest estimation period of empirical studies at that time (1965-1977) & included most of industrial nations Published on one of the most famous journal-Journal of International Economics and quoted for the most times in this area

3. Conculsion an increase in uncertainty reduces trade quantity (short-run) The long-run expectation of an increase in the real exchange rate increases trade quantity a relatively price inelastic short-run supply curve, but a relatively price elastic long-run curve.

4. Introduction & Motivation since the advent of the floating exchange rate regime in 1973, the widely-discussed question has been whether the increase in exchange rate variability has affected international trade flows.

5. Introduction & Motivation The work of Ethier (1973), Clark (1973), Baron (1976), and Hooper and Kohlhagen (1978) theoretically proved that the variation of the nominal spot (or forward) exchange rate as the source of exchange rate uncertainty can reduce trade volume But little empirical works proved that. Clark and Haulk (1972),Makin (1976),Hooper and Kohlhagen(1978)

6. Hooper-Kohlhagen Framework Quantity of Exports Nominal export price The signs on the letters mean that the expected effect (positive or negative) on the Q and P

7. The Meaning of Each Variables Q=quantity of exports Pn*= nominal export price given in exporter's currency Y= money income in importing country CU=importer's nonprice rationing (capacity utilization used as proxy in Hooper-Kohlhagen) UC, UC* =importer's and exporter's unit cost, respectively PD = importer's domestic price level EH, EH* =expected cost of foreign exchange for the importer and exporter, respectively (the cost of exchanging foreign currency?) =standard deviation of the future spot rate

8. Modification of Previous Framework Hooper-Kohlhagen effort assumed nominal profit maximization and uncertain nominal exchange rates Cushman assumed real profit maximization and uncertain foreign and domestic price levels in addition to uncertain nominal exchange rates So, Cushman used the volatility of real exchange rate. * But the later studies tended to use the nominal exchange rate as an indicator:IMF(1984) (assume that the price and wage change a little in the short term )

9. Modification of Previous Framework Reason for using the real exchange rate: to the extent price changes offset exchange rate movements exchange risk will be reduced In order to hedge the future contracts, assume that all prices and wages within a country grow at one common inflation rate.

10. Used Variables X =future price of importer's currency in terms of exporter's currency Pn,Pn* =future nominal export price in importer's and exporter's currency, respectively PD, PD* =future importer's and exporter's price levels q,q* =export quantity, the prices of which are to be denominated in importer's and exporter's currency, respectively Then:

11. Deflated Variables How to calculate the real variables: R = (X·PD*)/PD = real exchange rate, P*= Pn*/PD*= real export price in exporter's currency P =Pn/PD=real export price in importer's currency

12. Exchange Risk If all prices and wages grow at the constant inflation level, the only risk comes from the real exchange rate. Decompose the real exchange rate in this way: R = R0 • where R0=current known level and =the uncertain growth rate of R. Theta equals the uncertain growth rate of the exchange rate times the uncertain relative inflation rates.

13. Exchange Risk the exporter's expectation variable is =100·(Rt/Rt-1) R or increase (depreciate the exporter currency), future trade appears relatively more profitable to both exporters and importers, while an increase in indicates increased future riskiness

14. Empirical Estimation Based on the previous model, EH and EH* replaced by R and , and replaced by The model is (M for , S for ) D is a dummy variable, which indicates dock strikes M, S and D lag one quarter

15. Estimation Results Y: the importing country's real income clearly shows the standard effect on import demand. CU: both positive and negative (expected). UC: significantly negative. R: real exchange rate exhibit predominately significantly positive sign. D: The dock strike dummy is significantly positive

16. Estimation Results by M: mostly significantly negative (expected positive), the evidence indicates that current trade might vary inversely with current changes in M exchange rates affect trade flows in the long run to a greater extent than in the short run. S: results show that in most cases, the exchange risk has a significantly negative effect on trade quantity

17. Results on Prices M and R is ambiguous in the results S has not clear effect on PX

18. Conclusions The long-run expectation of an increase in the real exchange rate (an increase in M) increases trade quantity (short-run has not such effect) an increase in uncertainty in S reduces trade quantity. Price effects depend upon currency of contract denomination and other factors.

19. Further Studies an investigation of export behavior for more recent periods of time could test whether unpredictable deviations of the real exchange rate have lessened whether firms have become more adept at accommodating themselves to these risks.

20. Further Readings Rainer Frey: Exchange Rate Volatility and International Trade – Some GARCH Estimations Stress the Importance of Trade Diversification Piet Sercua; Raman Uppalb : Exchange rate volatility and international trade: A general-equilibrium analysis Hui-kuan Tseng: Does international trade stabilize exchange rate volatility? Reza Siregar and Ramkishen S. Rajan: Impact of Exchange Rate Volatility on Indonesia’s Trade Performance in the 1990s