Currency Hedging and Goods Trade

Abstract

A puzzle in empirical international finance is the difficulty in finding a large and negative effect of exchange rate volatility on international trade. A common explanation is the availability of hedging instruments. This paper examines the empirical validity of this explanation using data on over 1,000 country pairs. Which countries have currency hedging instruments is not perfectly observable. This paper deals with the problem by specifying an endogenous regime-switching regression. There are two main findings. First, there is no evidence in the data to support the validity of the hedging hypothesis. Second, for country pairs with large trade potential, exchange rate volatility deters goods trade to an extent much larger than that typically has been documented in the literature (without using the switching regression specification).