International Trade and the Risk in Bilateral Exchange Rates

Abstract

Exchange rate volatility falls after a trade deal, driven by a decline in the systematic component of risk. The average trade deal increases trade by 50 percent over five years, reducing systematic risk by a third of a standard deviation across countries. We examine this connection in an Armington model where the structure of trade networks determines the risk in exchange rates. We estimate our model to current data and find i) that countries at the periphery of the world trade network benefit the most from lower trade barriers and ii) that a counterfactual experiment of a trade war between the US and China shows a global increase in currency risk, with effects concentrated among peripheral countries.

Keywords: exchange rates, factor models, networks, trade agreements

JEL Classification: F11, F31, G15