# 1 Introduction

A long literature has studied the impact of exchange rate volatility and exchange rate regimes on trade ows.<sup>1</sup> The initial motivation behind this literature was the idea that, in absence of access to hedging mechanisms, risk averse exporters would be adversely aected by currency risk and exports would be reduced (Clark (1973)). This simple mechanism rests on a series of assumptions and has been challenged both theoretically and empirically. Overall, the current consensus seems to be that there is at most a weak negative eect of exchange rate volatility on aggregate trade ows.

A shortcoming with most of the literature is the focus on the impact of exchange rate volatility on the aggregate volume of trade. From a theoretical perspective, what really matters for a trading rm is the volatility of its prots. How this volatility relates to the volatility of exchange rates depends on how this rate correlates with a rm's price and costs. In other words, what really matters for a rm is the volatility of its individual real exchange rate. For instance, Clark (1973) highlights the importance of the use of imported inputs as a natural hedge against uctuations on the exchange rate. More recent papers also discuss the role of currency derivatives in reducing exposure to exchange rate risk (Wei (1999)).

Unless the prices and costs of all rms in a country are equally correlated with the nominal exchange rate, exchange rate uctuations may have consequences for the composition of trade, even without having a large impact on the aggregate trade volume. This is consistent with recent empirical evidence showing that the impact of exchange rate volatility varies across broad groups of sectors. For instance, Broda and Romalis (2003),Clark et al. (2004), and Byrne et al. (2008) show that rms producing homogeneous goods tend to be relatively less aected by exchange rate volatility than rms producing dierentiated products.

This paper studies the impact of exchange rate volatility on the structure of trade using detailed sectoral trade data. It starts from the simple premise that nominal exchange rate volatility should aect relatively less the trade of those rms and industries whose prots do not uctuate much as a result of exchange rate movements. In particular, industries exporting goods whose international price co-moves negatively with nominal exchange rate uctuations, which I refer to as industries with a natural hedge against exchange rate volatility, should be relatively less aected. Firms exporting goods with this characteristic are naturally protected against exchange rate risk. Therefore, if this risk matters they should be relatively less aected by exchange rate volatility.

The possibility that this natural hedge oers some protection to rms is supported by existing evidence that rms whose income is positively correlated with the exchange rate, such as those in

> 1McKenzie (1999) surveys the traditional literature that used time-series methods to estimate the impact of a country's exchange rate volatility on its total trade and exports. The most recent literature has exploited detailed panel data on bilateral trade ows and used gravity equations to estimate the impact of exchange rate volatility, exchange rate regimes, and currency unions on bilateral or multilateral trade. See, for instance, Frankel and Wei (1993), Frankel and Rose (2002), Rose (2000), Rose and Van Wincoop (2001), Klein and Shambaugh (2006), and Tenreyro (2007), among others.Clark et al. (2004) provides a comprehensive recent survey.

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