Working Paper: NBER ID: w3644
Authors: Robert C. Feenstra; Jon D. Kendall
Abstract: We examine how exchange rate volatility affects exporter's pricing decisions in the presence of optimal forward covering. By taking account of forward covering, we are able to derive an expression for the risk premium in the foreign exchange market, which is then estimated as a generalized ARCH model to obtain the time-dependent variance of the exchange rate. Our theory implies a connection between the estimated risk premium equation, and the influence of exchange rate volatility on export prices. In particular, we argue that if there is no risk premium, then exchange rate variance can only have a negative impact on export prices. In the presence of a risk premium, however, the effect of exchange rate variance on export prices is ambiguous, and may be statistically insignificant with aggregate data. These results are supported using data on aggregate U.S. imports and exchange rates of the dollar against the pound. yen and mark.
Keywords: exchange rate volatility; export prices; risk premium; forward covering
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of risk premium (G19) | negative impact on export prices (F69) |
| risk premium (G19) | effect of exchange rate variance on export prices (F31) |
| exchange rate variance (F31) | pricing decisions (risk-averse exporter pricing in currency of importing country) (F31) |
| exchange rate variance (F31) | pricing decisions (exporter pricing in own currency) (F31) |
| risk premium is significant and negative for yen (G15) | effects of exchange rate variance on export prices differ across currencies (F31) |