Asymmetric Effects of Exchange Rate Volatility: Theory and Evidence

In this paper, I scrutinise the effect of exchange rate volatility on bilateral trade whilst making use of disaggregated positive and negative changes in volatility. The effect of positive and negative changes is shown to be asymmetric. Moreover, a negative effect of squared changes in the coefficient of variation of the exchange rate on trade is found. A combination of isoelastic utility and stochastic volatility provides a theoretical model that explicitly maps the influence of the variance of exchange rate volatility on trade. In this higher order approximation of a CRRA utility function, the notion of risk aversion is sufficient to explain aversion to the variance of volatility. Illustrative numerical examples indicate that the model is qualitatively capable of explaining both the sign and relative magnitudes of the empirical results. The degree of risk aversion and the maturity of the forward market are found to be moderating variables in this model.