metadata: authors: 0: author: Mundaca, Gabriela
count: World
docna: 0: docna: Exchange rate uncertainty and optimal
            participation in international trade
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,Trade Policy,International Trade and Trade Rules,Trade and Services,Economic Growth,Macroeconomic Management
teratopic: Law and Development,Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: Instead of just focusing on the effect
            of exchange rate levels (undervalued or overvalued exchange
            rates) on trade, this paper provides an analysis of the
            effects of exchange rate volatility levels on international
            trade. Intuitively, an increase in exchange rate volatility
            leads to uncertainty for agents participating in
            international trade, and such uncertainty might have a
            negative impact on international trade flows and
            participation, thereby reducing the advantages of world-wide
            specialization. This is especially crucial for countries
            where exchange rate derivatives markets are not yet well
            developed and the costs of hedging exchange rate risk are
            very high. The model here considers optimal decisions about
            participation in international trade under uncertainty about
            the exchange rate. The main conclusion is that a high level
            of exchange rate volatility can deter entrepreneurs from
            becoming exporters, even though exporting can be highly
            profitable. For those already participating in international
            trade, it is opposite: they may, optimally, choose not to
            leave the market even though staying in this market is
            highly unprofitable in the short run.
repnme: repnme: Exchange rate uncertainty and optimal
            participation in international trade
display_title: Exchange rate uncertainty and
            optimal participation in international trade
listing_relative_url: /research/2011/03/13916386/exchange-rate-uncertainty-optimal-participation-international-trade
topicv3: Impact of Trade m1326020 1192,Economic Growth m1326241 471,Trade m1326924 698,Trade in Services m1326928 780,Monetary Policy m1327609 444
publishtoextweb_dt: 2011-03-01T00:00:00Z
historic_topic: Law and Development,Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 10
model_extractions: WPS5593 Policy Research Working Paper 5593 Exchange Rate Uncertainty and Optimal Participation in International Trade _Gabriela Mundaca_ The World Bank Development Economics Prospect Group Emerging Global Trends Team March 2011
Policy Research Working Paper 5593

# **Abstract**

Instead of just focusing on the effect of _exchange rate levels_ (undervalued or overvalued exchange rates) on trade, this paper provides an analysis of the effects of _exchange rate volatility levels_ on international trade. Intuitively, an increase in exchange rate volatility leads to uncertainty for agents participating in international trade, and such uncertainty might have a negative impact on international trade flows and participation, thereby reducing the advantages of world-wide specialization. This is especially crucial for countries where exchange rate derivatives markets are not yet well developed and the costs of hedging exchange rate risk are very high. The model here considers optimal decisions about participation in international trade under uncertainty about the exchange rate. The main conclusion is that a high level of exchange rate volatility can deter entrepreneurs from becoming exporters, even though exporting can be highly profitable. For those already participating in international trade, it is opposite: they may, optimally, choose not to leave the market even though staying in this market is highly unprofitable in the short run.

This paper is a product of the Emerging Global Trends Team, Development Economics Prospect Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at gmundaca@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Exchange rate uncertainty and optimal participation in international trade**

**_Gabriela Mundaca_** The World Bank

> * The views and conclusions expressed in this paper are from the author’s alone, and in no way reflect those of the World Bank, its Executive Directors, or the countries they represent.
# **1. Introduction**

Recent developments of the international monetary system have reinvigorated the policy debate over the pros and cons of different current exchange rate regimes. One topical issue in this recent debate is the effects of undervalued exchange rates on trade, a policy that has been followed by export-led countries to achieve economic growth. These economies are expected to move toward more flexible exchange rates, thus making it easier for each of these countries to insulate themselves from foreign shocks and benefit from a more independent monetary policy. Instead of just focusing on the effect of _exchange rate levels_ (undervalued or overvalued exchange rates) on trade, this note provides an analysis of the effects of _exchange rate volatility levels_ on international trade. Intuitively, an increase in exchange rate volatility leads to uncertainty for agents participating in international trade, and such uncertainty might have a negative impact on trade flows, thereby reducing the advantages of world-wide specialization.

I assume that firms are risk-averse, which implies that they care about not only their expected profits but also the risk premium associated with their returns to exporting. The exchange rate variance will then be an important component in the objective function of the exporters. Optimal decisions made by participants regarding whether to participate or not in international trade depend on the (upper and lower) margins of variance of the exchange rate. The latter represents uncertainty which I consider to be particularly crucial for new young firms that evaluate whether or not to participate in trade markets. The analysis of such issues represents a notable contribution to the literature. The costs of entry for firms entering the export market are assumed different from the costs of exit for those already in the market.

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Krugman (1989) and Dixit (1989a) are those in the literature closest to the approach proposed here. Their approaches are however limited to studying only how the distance between the highest and the lowest _levels_ of the exchange rate (e.g. the _width of the exchange rate band_ ) might affect firms’ participation in international trade. It is then important again to stress that in Krugman’s and Dixit’s models, only the highest and lowest value of the exchange rate _levels_ matters. Note that in their model, in contrast to what I present here, risk aversion does not play an important role and as a consequence neither the exchange rate volatility. Both authors assume that the exchange rate follows a Brownian motion process. They study cases where the possibility of exiting or entering the international trade markets has an option value for the firms. These firms may or may not exercise their options to enter into or to exit from international trade markets.

The model proposed here then represents a relevant alternative which provides new insight into the relationship between international trade and exchange rate volatility through the exchange rate volatility channel. Considering that the exporting firms’ decisions to enter and exit the export market depend on both the level and variance of the exchange rate is important, unless the fluctuation area for the exchange rate becomes common knowledge to the public, as in the regime of target zones for the exchange rate. My approach becomes essential for cases in which it is difficult to predict the equilibrium level of the exchange rate (including cases in which the exchange rate follows a random walk). After all, it is well known that it is less troublesome to predict the variance than the level of the exchange rate, and entrepreneurs would rationally take advantage of such information.

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On the empirical front, there is yet no strong consensus on the relationship between exchange rate volatility and trade.<sup>1</sup> Several factors can explain this tenuous relationship: (i) the availability of hedging techniques could make it possible for traders to avoid most of the potential exchange risk at little cost; (ii) there could be substantial _pricing to market_ which implies that firms selling goods in other countries do not have the prices charged in the importing country changed as much as one might otherwise expect; and iii) firms planning to enter the export sector incur _sunk costs,_ that is, substantial investments in resources to adapt their products to the foreign markets, in market development and distribution networks, and in creating production capability geared at foreigners’ preferences.

# **2. The Model**

Consider a risk-averse firm that is able to sell a good in the foreign market. Whenever a firm decides to participate in international trade, it needs to incur a fixed cost _F_<sup>_I_</sup> in domestic currency. _F_<sup>_I_</sup> is sunk after being incurred. A firm that reenters in the export market will need to incur another such a cost. While a firm that continues being an exporter faces another fixed cost, _F_<sup>_O_</sup> _. F_<sup>_I_</sup> is assumed to be larger than _F_<sup>_O_</sup> , which means that the entry cost can be recovered on exit. Firms, whether they decide to produce to the domestic market or the export market, incur in variable costs equal to V which do not need to be related to the exchange rate. The decision to enter or exit the trade market is an investment decision that renders returns. We assume that these returns are highly correlated with the level of the exchange rates. Thus, returns become

> 1 Abrams (1980), Thursby and Thursby (1987) find large negative effects of nominal variability on trade; while Eichengreen and Irwin (1996) and Frankel (1997) report a negative but small effect. On the other hand, Rose (2000), Engel and Rose (2000), Frankel and Rose (2002), amd Alesina, Barro and Tenreyro (2002) find that the effects of currency unions and unilateral dollarization on trade are positive and large. Tenreyro (2004) finds that there is no effect of exchange rate variability on trade.

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uncertain because of the exchange rate but not because of the prices of exported goods since firms practice the pricing to market policy.

The possible returns from entering the export market take values _r_<sup>_I_</sup> _1_<sup>, rI</sup> 2<sup>, ..., rI</sup> n with corresponding probabilities. These series of possible returns, are represented by _I I r_  , have expected value equals to θ<sup>I</sup> (E[ _r_ (θ)]=θ<sup>I</sup> ), and variance σ<sup>2,I</sup> , and they are the same for all firms entering (or reentering) the export market. The potential returns from continuing in the market are _r_<sup>_O_</sup> _1_<sup>, rO</sup> 2<sup>, ..., rO</sup> n<sup>also with corresponding</sup> _O_ probabilities. We shall represent these returns by _r_  . Similarly, these returns have mean θ<sup>O</sup> and variance, σ<sup>2,O</sup> . Also here θ<sup>O</sup> and σ<sup>2</sup> are equal for all firms considering continuing being exporters. The differences in the distributions may be due to entrepreneurs that are already in the market having different opportunities to manage exchange rate risk and information from those already in the market. The return for only selling in the domestic market is however a certain price one and equals **P.** Each entrepreneur has an initial income equal to _W0_ > 1, and a CARA<sup>2</sup> utility function.

The entrepreneur that evaluates _entering_ (or reentering) the trade markets has the following expected utility out of net returns minus the sunk costs ( _W0 – F_<sup>_I_</sup> _-V + I r_ (  ) ):<sup>3</sup> ( _1/2_ <sup>_2,I_</sup> ) is the risk premium he would be willing to give up rather than face the exchange rate risk. With a CARA utility function, this risk premium depends on the variance of the uncertain return.

> 2 CARA stands for Constant Absolute Risk Aversion.

> 3 The derivation of (1a) is not reported due to space constraint.

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An entrepreneur that _remains_ in the export market has the following expected utility out of returns minus the costs of staying the market ( _W0 – F_<sup>_O_</sup> _-V+ r I_ (  ) ): ( _1/2_ <sup>_2,O_</sup> ) is also a risk premium for this type of entrepreneur.

An entrepreneur who only participates in the domestic market will obtain utility equal to _u(W0 - V + P)._ An entrepreneur will choose to continue participating in or entering the export market if, by doing so, he derives a higher utility than the one selling only in the domestic market. We translate this into the following conditions: _An entrepreneur will enter the market if:_ But (2a) is satisfied if: _Similarly, an entrepreneur may still want to continue being an exporter if:_ But (2b) is satisfied if: _M_<sup>_I_</sup> and _M_<sup>_O_</sup> are the Marshallian trigger returns for entering and remaining in the export market, respectively (similar to Dixit (1989b)). At a return between _M_<sup>_I_</sup> and 6
_M_<sup>_O_</sup> , a domestic firm does not take part in international trade, and a firm which is already active in international trade does not exit.

Now, as the sunk cost, _F_<sup>_I_</sup> , and the fixed cost of remaining being exporters, _F_<sup>_O_</sup> , both tend to zero, _θ_<sup>_I_</sup> _– 1/2_ <sup>_2,I_</sup> and _θ_<sup>_O_</sup> _– 1/2_ <sup>_2,O_</sup> tend to _P_ , the return to participating only in the domestic market. The inequalities (3a) and (3b) will remain even when _F_<sup>_I_</sup> or _F_<sup>_O_</sup> becomes zero. That is, if the sunk costs for the entrepreneur evaluating whether to participate in international trade, _F_<sup>_I_</sup> _,_ becomes zero, the entering trigger _θ_<sup>_I_</sup> _– 1/2_ <sup>_2,I_</sup> has to be still above P. In addition, for a firm knowing that by not participating in international trade now, it can avoid _F_<sup>_O_</sup> for being an exporter whenever future development of the exchange rate level and volatility turn unfavorable. It is also important to notice that the _greater the range of uncertainty in the exchange rate (greater variances_ <sup>_2,I_</sup> _and_ <sup>_2,O_</sup> _) widens the range of inaction_ (e.g. the range between _M_<sup>_I_</sup> and _M_<sup>_O_</sup> ) _._ Therefore, the exchange rate volatility is the major variable that exporters will take into account to make optimal decisions about their participation in international markets, and possibly to adjust to relative changes in international relative prices to be able to remain exporting.

# **3. Conclusions**

I have presented a model of optimal decisions about participation in international trade under uncertainty about the exchange rate. The main conclusion from the model is that the greater the volatility levels of the exchange rate, the higher are the trigger returns at which it becomes optimal to enter or respectively exit the export market.

A consequence of this result is that a high level of exchange rate volatility can deter certain entrepreneurs from becoming exporters, even though exporting can be 7
highly profitable. For those already participating in international trade, it is opposite: they may, optimally, choose not to leave the market even though staying in this market is highly unprofitable in the short run.

# **References**

Abrams, R. K., 1980. Actual and potential trade flows with flexible exchange rates,” Federal Reserve Bank of Kansas City Working Paper No. 80 – 101.

Alesina, A., Barro, R., and Tenreyro, S., 2002. Optimal currency areas. NBER Working Paper No. 9072.

Dixit, A., 1989a. Hysteresis, import penetration, and exchange rate pass-through. The Quarterly Journal of Economics 104, 205 – 228.

Dixit, A., 1989b. Entry and exit decisions under uncertainty. The Journal of Political Economy 97, 620 – 638.

Eichengreen B. J. and Irwin, D. A., 1996. The role of history in bilateral trade flows. NBER Working Paper No. 5565.

Engel, C. and Rose, A., 2000. Currency unions and international integration. Journal of Money, Credit and Banking 136, 381 – 400.

Frankel, J., 1997. _Regional trading blocs in the World Economic System_ . Washington, D.C.: Institute for International Economics.

Frankel, J. and Rose A., 2002. An estimate of the effect of currency unions on trade and growth. Quarterly Journal of Economics 117, 437 – 466.

Krugman, P., 1989. _Exchange rate instability_ . MIT Press, Cambridge, Massachusetts.

Tenreyro, S., 2007. On the trade impact of nominal exchange rate volatility. Journal of Development Economics 82, 485 – 508.

Thursby, J. and Thursby M., 1987. Bilateral trade flows, the Linder Hypothesis, and exchange rate risk. The Review of Economics and Statistics 69, 488 – 495.

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