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International Trade and the Risk in Bilateral Exchange Rates
(with Ramin Hassan, Alexandre Pecora and Colin Ward)

Forthcoming at the Journal of Financial Economics

First version: April    2021
This version:  February 2022


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Abstract:

Exchange rate volatility falls after a trade deal, driven by a decline the systematic
component of risk. The average trade deal increases trade by 50 percent over 5 years,
leading to a 30 percent decline in the systematic risk of exchange rate. We examine
the connection between exchange rates and international trade in the light of an
Armington model. The nature of trade networks determine the risk in exchange rates,
and countries at the periphery benefit the most from lower trade barriers. We estimate
our model to current data, and run a counterfactual experiment simulating a trade war
between the U.S. and China. Our simulation shows a global increase in currency risk,
with most of the effects concentrated amongst countries at the periphery of the global
trade network.







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