Journal of Economic Studies

The effect of exchange-rate risk on exports: Some additional empirical evidence

Hongwei Du Zhen Zhu

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Journal of
Economic
Studies
28,2
106

The effect of exchange-rate

risk on exports
Some additional empirical evidence
Hongwei Du

College of Business Administration, Midwestern State University,

Wichita Falls, Texas, USA, and

Zhen Zhu

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College of Business Administration, The University of Central

Oklahoma, Edmond, Oklahoma, USA
Keywords Exchange rates, Risk, Export
Abstract This paper provides some additional empirical evidence on the effect of exchange-rate
volatility on exports. The novelties of the study include: a regime-switching model in conditional
volatility is employed to better capture the exchange-rate uncertainty; a 2SLS method as
suggested by Hsiao is used to estimate a system of the dynamic export equations; and an attempt
has been made to reconcile the empirical findings with existing theories. We find that the regimeswitching model captures the exchange-rate risks better and the empirical evidence by and large is
consistent with Viaene and Vries, who argued that the existence of the forward markets and
current account positions of the country would determine the impact of the exchange uncertainty
on trade.

Introduction
It is generally agreed that exchange-rate uncertainty has important
implications for international trade, efficient resource allocation, and thus the
choice of international financial systems. Theoretically, the effect of exchangerate uncertainty on trade can be ambiguous; however. Gagnon (1993) set up a
dynamic optimizing model of risk-averse traders that is characterized by
adjustment costs and rational expectations and found that uncertainty
depresses trade with various parameter values of the model. However, Dellas
and Zilberfarb (1995) found that a positive effect of exchange-rate variability on
trade can be consistent with the theories, and the impact depends on the degree
of risk aversion. A reasonable degree of risk aversion could imply a positive
effect[1]. Viaene and de Vries (1992) suggested that the straightforward
assumption of a negative relationship may not be appropriate. They suggested
that the existence of an exchange forward market is very important since the
exporters can hedge against exchange-rate risks in the forward market. When a
forward market is absent, a higher exchange risk or volatility would lead to a
decrease in volume of trade. But in the presence of a well-developed forward
market, the impact could be positive and the sign of the impact depends on
current account position of the country. Obviously, the effect of exchange-rate
Journal of Economic Studies,
Vol. 28 No. 2, 2001, pp. 106-121.
# MCB University Press, 0144-3585

An earlier version of the paper was presented at 1997 Western Economic Association
International Annual Meetings in Seattle. Ling-Wei Chung provided research assistance.

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uncertainty on trade and to what degree the risk can be hedged against is an
empirical issue. The resolution of the issue has important policy implications,
since if the negative effect is significant statistically and large economically,
policy to limit exchange-rate fluctuation such as some form of exchange-rate
control (a target zone, for example) may be deemed to be necessary.
The empirical evidence, however, is mixed. The results often differ with
samples and estimation methods (e.g. Cushman, 1988). There is no consistent
pattern of the effect when the same method is applied to different countries (e.g.
Kroner and Lastrapes, 1993) or when the same country (typically, the USA) is
examined for different periods. While many would expect that exchange-rate
uncertainties depress international trade and found evidence supporting the
view (Arize, 1995; Pozo, 1992), many also found that exchange-rate
uncertainties affected international trade positively (Asseery and Peel, 1991)[2].
There are at least three difficulties with the existing empirical literature. The
first is the measurement of the risk. The second is the complication in model
specifications due to the nonstationarity of the variables. The third is the lack
of consistency of the empirical findings with existing economic theories. This
paper tries to add to the literature in each of the three areas.
It is realized that the traditional measure of exchange-rate uncertainty
usually the moving average of the standard deviation of the past exchange
returns is not an appropriate proxy for exchange-rate risk since it does not
fully capture the features of the volatility and utilize all information such as the
stochastic process generating the exchange-rate. Generalized autoregressive
conditional heteroscedasticity (GARCH) models of exchange-rate volatility
then are used to model the uncertainty and to capture the feature of
leptokurtosis in the distribution of the exchange returns. However, it has been
shown that the persistence in conditional volatilities of financial variables may
be due to regime shifts. Hamilton and Susmel (1994), among others, suggested
that when shifts in regimes in conditional volatilities are modeled, the
persistence in the stock return volatilities can be substantially reduced. In the
foreign-exchange market, changes in policy regimes could have affected the
data generating process of the exchange-rate, and thus shifts in conditional
volatilities may be likely. Failing to model the shifts in conditional volatilities
may seriously affect the risk measurement, and thus impair the analysis of the
effect of the risk on exports. In this paper, we show that the volatility measures
generated by GARCH (1,1) models are highly persistent and some of them may
contain unit root. We then use the method of Hamilton and Susmel (1994) to
model risks and find that the volatilities have low degrees of persistence. This
approach seems to be an improvement since once there is a change in regimes,
the change ought to be incorporated into the rational agents' forecasting
equation.
The more recent empirical literature also realized that the macroeconomic
variables used in the studies often are nonstationary. Therefore, conventional
regression method may not be appropriate (Arize, 1995; Pozo, 1992; Kroner and
Lastrapes, 1993, among others). This, unfortunately, leads to differences in

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model specifications, and empirical results. For example, using an augmented

Dickey-Fuller (1979) test and Phillips-Perron (1988) test, Kroner and Lastrapes
(1993) and Pozo (1992) found that the volatility measures are stationary, thus
volatility measure cannot be cointegrated with other nonstationary variables
that would be expected to determine trade[3]. For the case of the USA as well,
however, Arize (1995) found that the volatility generated by an ARCH model is
nonstationary and is cointegrated with other variables. Their estimated
equations thus differ in specifications. It is not surprising that their estimates of
the impact parameters differ in signs and magnitudes. We use the Two Stage
Least Squares (2SLS) method to avoid the confusion in model specification. As
suggested in Hsiao (1997), in a dynamic structural model where the variables
are nonstationary and cointegrated, the OLS method is not consistent, but the
2SLS method would be consistent.
This study also represents one of the first attempts to reconcile the empirical
findings with theories. To our knowledge, previous studies focused exclusively
on examining whether the impact of the exchange-rate risk on exports is
positive or negative, employing various measures of the risk for various
samples. None has tried or been able to explain the relationship between
exchange-rate volatility and exports. This paper suggests that a mechanism
explained by Viaene and de Vries (1992) may be supported by our empirical
findings.
The paper is organized as follows. The second section discusses empirical
models and risk measurement. The third section presents empirical results. We
first show the evidence of regime shifts in conditional volatilities, and then
report the impact of the exchange-rate risk on export estimated using the
seemingly unrelated regression method with instrumental variables. Finally,
we show our results in light of the theories developed by Viaene and Vries
(1992). The fourth section concludes.
Model specification and econometric issues
Model specification
The conventional export-demand function can be specified as follows:[4]
EXt 0 1 Yt 2 Pt 3 Et Vt1 "t ;

where EX*t is the desired real export or export volume, Y*t the real foreign
income level[5]. Pt is the measure of competitiveness and it is the real effective
exchange-rate expressed as the foreign currency price of the domestic
currency[6]. Pt measures the terms-of-trade effect. EtVt+1 is a measure of
forecast of the nominal exchange-rate risk in time t + 1. "t is the white-noise
error term. All the variables are in logs, therefore the parameters measure the
elasticity of export demand. According to the theories, 1 should be positive, 2
should be negative. However, the effect of the risk on trade is less clear.
One serious limitation of the above formulation is the assumption of
instantaneous adjustment of exports to foreign income, real exchange-rate and

exchange-rate risks. We assume a partial adjustment model of the following

form:[7]
2

EXt EXt EXt 1 ;
where
EXt = EXt EXt1 is the actual change in real exports.  is the
coefficient of adjustment. Substituting (1) into (2) yields the following dynamic
linear export demand function:
EXt

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0 1 Yt 2 Pt
a0 a1 Yt a2 Pt a3 Vt

3 Vt 1
a4 EXt

EXt
vt :

"t

The coefficients in the above equation give us short-run elasticities while the
coefficients in equation (1) give us long-run elasticities. However, the
coefficients of (1) can be obtained directly from the coefficients of (3).
As mentioned in the introduction, the variables in the above equation are
likely to be nonstationary, thus rendering the OLS estimates inconsistent.
Recent studies either applied cointegration and error correction techniques or
estimated the differenced-variable version of the model. In this paper, we follow
the suggestion of Hsiao (1997) to use an instrumental variable method.
Specifically, we use (Xt, Xt1) to be instruments for (Xt, EtXt+1) where Xt is the
variable vector of the exogenous variables, Y*t, Pt and EtVt+1. The system of
the dynamic equations is estimated in a SUR with corrected full system
covariance structure to take into account the cross equation correlations which
are most likely to be the case for the multiple equation system.
The measurement of exchange-rate risk
The traditional measurement of the exchange-rate risk involves the moving
average of the standard deviation of the exchange returns. However, it is
pointed out (Engle, 1982) that only conditional volatility matters since it
contains more relevant information for forecast purposes. The moving average
formulation of the risk is not consistent with the rational behaviour of the
economic agents. Several authors used conditional volatility models such as
ARCH or GARCH (Kroner and Lastrapes, 1993; Pozo, 1991; Arize, 1995), among
others). One common finding is that the exchange-rate volatilities modeled this
way are highly persistent and may contain unit root. This implies that the
volatility measure may be nonstationary and needs to be first-differenced
before it can be used in a regression, or when there is a cointegrating
relationship among the variables, an error correction model needs to be
estimated. However, the persistence in the conditional volatilities may be
spurious, leading to unnecessary first differences and inaccurate measurement
of the risks. Hamilton and Susmel (1994), among others, suggested that the
persistence may be spurious due to possible regime shifts in conditional
volatilities[8].
Regime shifts in the conditional volatilities in the foreign exchange markets
are highly likely in the post-Bretton Woods regime. For example, in Europe, the

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exchange rates of several countries have been subject to realignments. In

addition, turmoils in the foreign exchange markets have led countries like the
UK and Italy to exit the European Monetary System in 1992. These events
could have affected the exchange-rate volatility in a specific way. Thus we
consider this possibility of regime shift in volatilities by employing the model
of Hamilton and Susmel (1994) to model the risk.
Following Hamilton and Susmel, we model the residual "t from an
autoregression of nominal exchange rate as:
p
"t gst et
4
where st is a subscript representing the state of the conditional volatility and st
is assumed to follow a first-order Markov process. In our case, we assume that
st can be described as a Markov chain:
Probst jjst

i; st

Probst jjst

k; . . . ; "t 1 ; "t 2 ; . . .
5

Pij ;
for i, j = 1, 2, . . ., k. Pij is the transition probability and it measures the
likelihood of state i in time t 1 changing to state j in time t. Thus, the variable
st modeled this way represents a ``state`` or ``regime'' that a process is in at date t.
Therefore st governs the parameters of the conditional distribution of "t. We
can thus view g" t as the scaling factor that distinguishes one regime of the
conditional volatility from another.
In equation (4), et is assumed to follow a standard ARCH(q) process:
et ht ut ;
with ut a zero mean, unit variance i.i.d. sequence, while ht obeys:
ht 2 a0 a1 e2t

a2 e2t

. . . aq e2t q :

The above model suggests a way to model conditional volatilities. We may

obtain the estimate of the conditional variance of residual et by multiplying et
by the constant g1 when the process is in the regime represented by st = 1, and
by g2 when the process is in the regime represented by st = 2, and so on. In
other words, the conditional variance of a process in time t is the weighted
average of conditional variances in different states, with the weights being the
probabilities of the state the process is in. We can maximize the log-likelihood
function characterized by these states and associated conditional means and
variances, and then obtain the parameter estimates as well as forecasts of the
variances. In the process, we may normalize the scaling factor for the variance
in state 1 to be 1.0[9].
The usual ARCH or GARCH estimation of the volatilities is a special case of
the above model since it is equivalent to the case when gk = 0 for k 6 1 and the

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likelihood of a process staying in state k is essentially zero. In the regimeswitching model, the likelihood of a process staying in a particular state will be
characterized by probabilities. These probabilities of the states will be inferred
from the full-sample data along with other parameter estimates characterizing
the conditional distribution of the processes.
In modelling the exchange-rate, we assume that the exchange-rate follows a
random-walk process. This is consistent with the established literature on the
properties of the exchange-rate (e.g. Meese and Rogoff, 1983).
Data and empirical results
Data
We estimate the export equation for six industrial countries: the USA, UK,
Japan, Sweden, France, and Italy for the post-Bretton Woods era. The sample is
chosen for the availability of data in general for the period of 1974:1 to
1995:4[10]. We define the variables in the following way. We divide the export
values in local currency by export price indices of the corresponding countries
to obtain the measure of real export. We use real effective exchange-rate as the
measurement of the relative prices of goods. Since we estimate aggregate
export equations for the countries involved, we need a world income
measurement. We use the production index of industrial countries as the proxy
for the real world income[11]. When we measure the volatilities of the exchange
rate for each country, we use the nominal effective exchange rate[12]. In the
estimation, all variables are in natural logarithms. All quarterly data are
obtained from the CD-ROM version of the International Financial Statistics.
Risk measurement and regime switching in conditional volatilities
We estimate a GARCH(1,1) model first to obtain the exchange-rate risk
measure. The model we estimate is of the following form:
p

ERt a0 et et vt ht ; vt  N 0; 1; ht b0 b1 ht 1 b2 e2t 1
where
ERt is the exchange-rate return, a0 the drift term, and et the residual. In
this conventional GARCH(1,1) model, the persistence of the volatility is
measured by the sum of the two coefficients b1 and b2.
Table I reports the GARCH model estimation results. Two countries, Italy
and the UK, had significantly negative drifts in exchange returns. In contrast,
Japan had a significantly upward drift in its currency return. Although the
USA, France and Sweden had downward drifts in their exchange rates, the
drifts are not statistically significant. We also observe high levels of persistence
in conditional volatilities. Four out of the six countries, the USA, Japan, France
and Sweden, had the persistence level of 0.9 or above. Especially for Sweden,
the point estimate of b2 in the conditional volatility equation exceeds 1.0 though
the coefficient estimate may not be statistically different from 1.
Since the high degrees of persistence could be due to regime switching in
conditional volatilities, we estimate the regime-switching model. In modelling

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Table I.
GARCH estimation of
the volatilities

The model estimated is:

ERt a0 et
p
et vt ht ; vt  N0; 1
ht b0 b1 ht
Countries

b2 e2t

a0

b0

b1

b2

France

0.0006
(0.0013)

0.00012
(0.00005)

0.0044
(0.0917)

0.951*
(0.289)

Italy

0.012*
(0.0037)

0.00037**
(0.0002)

0.2218
(0.38)

0.258
(0.206)

Japan

0.011*
(0.005)

0.00019
(0.00017)

0.866*
(0.093)

0.051
(0.068)

Sweden

0.0045
(0.0029)

0.00046*
(0.00009)

0.016
(0.066)

1.009*
(0.429)

UK

0.0074**
(0.004)

0.0002
(0.0002)

0.818*
(0.152)

USA

0.002
(0.003)

0.0001*
(0.00005)

0.889*
(0.077)

0.028
(0.082)

Notes:
ER is measured by the nominal effective exchange rate of respective countries
*
significant at 5% level
**
10% level
constrained estimation since the unconstrained estimate is negative

the ARCH effect, we find that the lags need not be large. Table II reports the
parameter estimates of a two-state regime-switching model. Column 1 is the
estimate of the drift term in the exchange-rate equation. The second column
reports the estimates of the constant terms in the conditional volatility
equations. b1 and b2 in columns 3 and 4 are the coefficients in the
autoregression of the conditional variances. Most of them are small and none of
them are now significantly different from zero. This result suggests that after
we consider the regime shifts, the conditional variances are no longer very
persistent. This also implies that the volatility cannot be nonstationary. The
estimates of the conditional-variance shifting factors in column 5 are all
significantly different from zero except for the case of the UK which has a t
statistic of 1.42. The magnitudes of g2 are in the order of four or more compared
to the normalized variances of the other state, suggesting that the changes in
the magnitude of the conditional volatilities are quite drastic accompanying the
change in the regime.
The transition probability estimates in the last two columns indicate that the
regimes are in general persistent except for the case of France for P22. For
example, in the case of the UK, once the regime is a low conditional variance
state, the regime would remain in the low volatility state for the next period

The effect of
exchange-rate
risk on exports

The model estimated is:

ERt a0 ERt 1 et
p
et gst "t
p
"t ht vt ; vt N0; 1
ht b0 b1 "2t

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With transition probabilities Pij ProbSt jnSt

b2 "2t
1

113

Country

a0

b0

b1

b2

g2

P11

P22

France

0.031
(0.072)

0.015*
(0.006)

0.458
(0.30)

0.08
(0.119)

5.59*
(3.58)

0.83
(0.13)

0.17
(0.20)

Italy

0.0066*
(0.0019)

0.002*
(0.0006)

0.136
(0.15)

0.124
(0.13)

18.59*
(8.19)

0.975*
(0.19)

0.973*
(0.17)

Japan

0.0055
(0.017)

0.044*
(0.014)

0.087
(0.15)

0.117*
(0.05)

0.94*
(0.22)

0.85*
(0.21)

Sweden

0.02*
(0.01)

0.05*
(0.017)

0.000
(0.05)

0.142
(0.15)

0.022*
(0.01)

0.862*
(0.21)

0.932*
(0.23)

UK

0.12*
(0.038)

0.002*
(0.001)

0.000
(0.011)

0.215
(0.28)

0.787*
(0.28)

0.898*
(0.27)

USA

0.017
(0.074)

0.0195*
(0.011)

0.000
(0.22)

0.208
(0.257)

0.988*
(0.21)

0.97*
(0.19)

14.85
(10.47)
0.258*
(0.095)

Notes:
*
Significant at 5% level. Standard errors are in parentheses

with a probability of 0.787. But once the regime is a high conditional volatility
state, the probability of remaining in the same state for the next period is 0.898.
In the case of Italy, each regime is very persistent with the probabilities
exceeding 0.97. But in the case of France, the high volatility state is generally
short in duration. The transition probability is merely 0.18.
One of the advantages of the regime-switching model is that it is informative
in revealing the time at which a regime switch could occur. The inference is
made easier by the fact that we could use probability estimates. Figure 1 plots
the exchange-rate, the conditional volatilities and probabilities of high
probability state for the USA. The volatility increased in the early 1980s. The
probability plots also indicate that the transition from low volatility to higher
volatility regimes lasted several years and finally the transition completed in
1981.
Figure 2 indicates that there are several episodes of low conditional
volatilities for the UK. The first is in the beginning of the sample period. The
second is in between 1983 and 1985. The third low volatility state occurred
before 1992. In Figure 3, Japan has shown a similar pattern. For the case of Italy
as shown in Figure 4, there are two higher volatility periods. The first one
occurred between the beginning of the sample and 1976. The second occurred

Table II.
Switching regime
ARCH estimation of
volatility

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Figure 1.
Regime switching in
USA FX conditional
variance

Figure 2.
Regime switching in UK
FX conditional variance

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Figure 3.
Regime switching in
Japan FX conditional
variance

Figure 4.
Regime switching in
Italy FX conditional
variance

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in 1992 and lasted until the end of the sample period. For Sweden (Figure 5), the
higher conditional volatility periods are from 1976 to 1978, 1981 to 1983, and
after 1992. For the case of France in Figure 6, the higher volatility states are
more sporadic throughout the sample period.
The divisions between the low volatility periods and high volatility periods
might be related to some events and policy changes. For most of the periods,
the timing seems to be related to the sharp changes in the exchange-rate[13]. In
some other cases such as in Italy, UK, Sweden and France, the turmoils in the
EMS in 1992 might have affected their conditional volatilities. In 1992, Italy
and UK exited the EMS system after joining it briefly. The third low volatility
period for the UK might be due to the participation in the system.
The effect of exchange-rate risk on exports
The results of the estimation are presented in Table III. The first column in
Table III provides the parameter estimates of the constant term. a1 in column 2
provides the terms of trade effect. In all cases, real exchange-rate appreciation
depresses export volume significantly. The short-run elasticities range from the
lowest for the USA ( 0.100) to the highest for France ( 0.61). Obviously, for the
studied period, Japan's export has been hurt by the increase in the value of their
currency while other countries such as France, UK, Italy and Sweden benefited

Figure 5.
Regime switching in
Sweden FX conditional
variance

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Figure 6.
Regime switching in
France FX conditional
variance

from their real currency depreciation[14]. Here one finds the conventional terms
of trade effect and this is consistent with previous empirical findings.
Column 3 of Table III reports the short-run income elasticity of export. In
general, world income significantly affected exports positively and significantly
except for the case of France. Sweden has the largest income elasticity (0.308)
while France has the smallest (0.003). For the USA, the estimate is 0.239, which is
consistent with other studies as well. Most of the point estimates are in the range
of 0.2 to 0.3, which means when the world income increases by 1 per cent, the
export of the countries would increase by 0.2 per cent in the same quarter.
The effect of exchange-rate volatility on export is reported in column 4. For
two countries, Italy and Sweden, real exchange-rate volatility had significantly
positive impacts on exports. For all other countries, exchange-rate risk tended
to depress trade, with a significant impact for the case of Japan only. The shortrun risk elasticities are generally small, in the range of 0.01 to 0.09, meaning
that a 1 per cent increase in the exchange-rate volatility would either increase
(in the case of Italy and Sweden) or decrease (in all other cases) export by 0.01 to
0.09 per cent.
We can obtain the estimates of the coefficients of adjustment (^p) by using the
information provided in column 5 of Table III:  = 1 a4. The magnitudes of
the coefficient of adjustment range from the highest of 0.32 for Japan to the

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Table III.
The estimation of the
export equations by
the SUR method

The regression equation takes the following form:

EXPt a0 a1 REt a2 Yt a3 Riskt a4 EXPt
where: EXP:
RE:
Y*:
Risk:

et

real export
real effective exchange rate
world income measured by industrial production
exchange rate risk measured by conditional variance

Country

a0

France

3.06*
(0.98)

0.61*
(0.17)

0.003
(0.079)

Italy

0.44
(0.46)

0.122*
(0.079)

Japan

0.46*
(0.17)

Swden

a1

a2

a3

a4

R2

0.016
(0.019)

0.91*
(0.024)

0.98

0.244*
(0.097)

0.029*
(0.01)

0.90*
(0.027)

0.98

0.417*
(0.052)

0.283*
(0.056)

0.099*
(0.025)

0.68*
(0.04)

0.94

0.454
(0.832)

0.403**
(0.176)

0.308**
(0.176)

0.044***
(0.026)

0.79*
(0.076)

0.95

UK

0.259
(0.397)

0.144*
(0.049)

0.215**
(0.105)

0.019
(0.026)

0.87*
(0.045)

0.94

USA

0.398*
(0.227)

0.100*
(0.025)

0.239*
(0.054)

0.012
(0.015)

0.88*
(0.03)

0.99

Notes:
The estimates are required by SUR method
*
Significant at 1% level
**
5% level
***
10% level
Standard errors of the estimates are in parentheses

lowest of 0.09 for France. For the case of the USA, the estimate indicates that
the full adjustment of the export to shocks to other variables in the system will
finish in 8.33 periods, or an equivalence of a little over two years. The estimates
suggest that exports take ten months to two years to adjust to exogenous
shocks in general.
The estimates in Table III suggest that the short-run elasticities are small.
However, the long-run export elasticities provided in Table IV indicate that for
most countries, the real exchange-rate and income elasticities of the exports are
more elastic, ranging from the highest of 6.77 for France (real exchange-rate)
and 2.44 for Italy (income). But the exchange-rate risk elasticities of exports are
relatively small for all countries. Thus, our results indicate that there is not
much significant economic impact of the exchange-rate risk on exports,
although for some countries, the impacts are statistically significant.
Exchange-rate risk effect, forward markets and current account position
We find that our results might be consistent with the theory put forth by
Viaene and de Vries (1992) who suggested that in the case of a well-developed

Country

Real exchange rate

Income

Exchange risk

France
Italy
Japan
Sweden
UK
USA

6.77
1.22
1.30
1.92
1.11
0.83

0.04
2.44
0.88
1.47
1.65
1.99

0.176
0.290
0.309
0.209
0.146
0.100

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Note:
The long-run real exchange rate elasticity of export is calculated as a1/(1a4), income
elasticity is calculated as a2/(1a4), and exchange risk elasticity as a3/(1a4), where the
parameter estimates are obtained from Table III

The effect of
exchange-rate
risk on exports
119
Table IV.
Long-run export
elasticities

forward market, the impact of exchange-rate risk on exports depends on the

trade position of the country: the effect should be positive for the surplus
countries and negative for the deficit countries. The countries involved in this
study have relatively well-developed forward markets. Therefore, we plot the
risk-effect estimates against the current-account positions in Figure 7. In Figure 7,
the current-account position is the average quarterly current account balances
over the studied period. The scatter plot shows that Sweden, Italy and Japan had,
on average, trade surpluses, while the USA, UK and France had trade deficits.
We find all countries fall in the first and third quadrants except for Japan.
Conclusion
Our study intended to contribute to the literature by providing more consistent
estimates of, and explanation of, the relationship between exchange-rate risk

Figure 7.
Risk-effect estimates
against current account
positions

Journal of
Economic
Studies
28,2

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120

and exports. We showed that the risks measured by conditional volatilities

obtained from GARCH estimation could be spuriously persistent and thus
inaccurate, and the spurious persistence may be caused by regime switching in
conditional volatilities. Various reasons could explain the regime shifts. For
example, the changes in the EMS exchange-rate arrangement might have
affected the conditional volatility regimes.
Using six industrial countries' data, we have found significantly negative
and positive, albeit small, impacts of exchange-rate risk on exports. Our results
can be consistent with Viaene and de Vries with an exception of Japan. The
impact may be dependent on the existence of a forward market and trade
position of a country. Further studies on countries without well-developed
forward markets may be expected to provide additional evidence regarding the
theoretical results of Viaene and de Vries and shed more light on the important
issue which has serious policy implications.
Notes
1. According to Dellas and Zilberfarb (1995), an increase in risk makes the consumer less
inclined to expose his/her resources to the possibility of a loss. This implies a negative
impact. On the other hand, higher riskiness makes it necessary to commit more resources
to savings (to export more) to protect oneself against very low consumption of the
imported good in the next period. Which effect dominates depends on risk aversion.
2. The earlier literature provides more conflicting results regarding the effect, see Kenen and
Rodrick (1986).
3. Cointegration requires each series in the variable vector to be integrated of the same order
of larger than 0.
4. See, for example, Arize (1995), and Kroner and Lastrapes (1993).
5. In the bilateral trade model, it is the income of an importing country. In our model where
Y*t is the real aggregate export, it should be the world income excluding the income of the
exporting country.
6. In some studies, it is the relative price of tradable goods such as domestic export price
deflated by foreign export price times nominal exchange-rate.
7. Khan and Ross (1977), among others, assumed the similar adjustment models for import
demand.
8. When the stock returns are modeled in a regime-switching system, Hamilton and Susmel
(1994) found that the persistence of the conditional volatilities has been substantially
reduced and the forecasting performances of the model are enhanced.
9. For details, see Hamilton and Susmel (1994).
10. For some countries, the real effective exchange-rate series may not be available for the
entire period. Therefore, we dropped them from the dataset.
11. This index does not exclude the income of exporting country. We use the index for the
following reasons. First, a good measure of the world income is hard to find and a
constructed series may still be criticized on the ground of inappropriate weights used.
Second, the income elasticity is not the major issue of the paper. Third, our empirical
findings suggest that the production index is a good approximation.
12. Since real and nominal effective exchange rates are closely related in the post-Bretton
Woods era, we do not expect that the use of real exchange-rate volatility to yield different
results.

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13. Obviously, the sharp changes in the exchange rate might be related to the realignment of
the exchange-rate in some European countries. The realignments in the Swedish nominal
exchange rate against mainly the countries in the European Monetary System have
obviously affected the nominal effective exchange-rate volatility.
14. Japanese yen has been appreciating and other countries' currencies have been depreciating
during the period.
References and further reading
Arize, A.C. (1995), ``The effect of exchange-rate volatility on US exports: an empirical
investigation'', Southern Economic Journal, July, pp. 34-43.
Asseery, A. and Peel, D.A. (1991), ``The effect of exchange rate volatility on exports'', Economics
Letters, October, pp. 173-7.
Cushman, D.O. (1988), ``US bilateral trade flows and exchange risk during the floating period'',
Journal of International Economics, Vol. 24, pp. 317-30.
Dellas, H. and Zilberfarb, B. (1995), ``Real exchange rate volatility and international trade: a
reexamination of the theory'', Southern Economic Journal, July, pp. 641-7.
Dickey, D.A. and Fuller, W.A. (1979), ``Distribution of the estimators from autoregressive series
with a unit root'', Journal of the American Statistical Association, Vol. 74, pp. 427-43.
Engle, R.E. (1982), ``Autoregressive conditional heteroscedasticity with estimates of the variance
of the United Kingdom inflation'', Econometrica, June, pp. 377-403.
Gagnon, J.E. (1993), ``Exchange rate variability and the level of international trade'', Journal of
International Economics, Vol. 269-87.
Hamilton, J.D. (1994), Time Series Analysis, Princeton University Press, Princeton, NJ.
Hamilton, J.D. and Susmel, R. (1994), ``Autoregressive conditional heteroscedasticity and changes
in regime'', Journal of Econometrics, Vol. 64, pp. 307-33.
Hsiao, C. (1997), ``Statistical properties of the two stage least squares estimation under
cointegration'', Review of Economic Studies, Vol. 64 No. 3, pp. 385-98.
Kenen, P.T. and Rodrick, D. (1986), ``Measuring and analyzing the effects of short-term volatility
in real exchange rates'', The Review of Economics and Statistics, Vol. 68, May,
pp. 311-15.
Khan, M.S. and Ross, K. (1977), ``The functional form of aggregate export demand function'',
Journal of International Economics, Vol. 7 No. 2, pp. 149-60.
Kroner, K.F. and Lastrapes, W.D. (1993), ``The impact of exchange rate volatility on international
trade: reduced form estimates using the GARCH-in-mean model'', Journal of International
Money and Finance, June, pp. 298-318.
Meese, R.A. and Rogoff, K.S. (1983), ``Empirical exchange rate models of the seventies: are any fit
to survive?'', Journal of International Economics, Vol. 14, February, pp. 3-24.
Phillips, P.C.B. and Perron, P. (1988), ``Testing for a unit root in time series regressions'',
Biometrica, Vol. 75, June, pp. 335-46.
Pozo, S. (1992), ``Conditional exchange rate volatility and the volume of international trade:
evidence from the early 1900s'', Review of Economics and Statistics, May, pp. 325-9.
Viaene, J.-M. and de Vries, C.G. (1992), ``International trade and exchange rate volatility'',
European Economic Review, pp. 1311-21.

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risk on exports
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