2 LITERATURE REVIEW

The Bretton Woods system collapsed in 1973, and after that the currency

exchange rates regimes of most countries became floating. It was hypothesized that

the volatility under flexible exchange rates might have a negative impact on trade.

This was based on the notion that risk averse traders will reduce trade volumes in the

event of increased exchange rate uncertainty. Therefore, this issue became an

interesting research question for many economists that embarked themselves into the

formulation of theories and the quest of empirical evidence to probe such hypothesis.

Some pioneer works in the theoretical literature are those of Ethier (1973) and Clark

(1973) which results, from the perspective of risk averse firms, supported the

hypothesis that exchange rate volatility negatively impacts trade. Deemers (1991)

found support to the negative effects without requiring the risk averse assumption, the

author instead assumed risk neutrality. However, Franke (1991) shows support for

positive effects of exchange rate risk on trade when assuming firms are risk neutral.

In theoretical works the direction of the effect is influenced by the assumptions made

about firms’ risk preferences, their decision making under different risk scenarios,

capital availability, traders’ time lags, and the firm’s business sector (McKenzie,

(1999)).

In the literature, there are various ways to estimate exchange rate volatility.

We divide them into two dominant schools. The researchers that used unconditional

and conditional measures of volatility. Unconditional measures can be the ad hoc

estimates of volatility such as moving standard deviation and coefficient of variation

(e.g., Cushman 1983, 1986, 1988a,b; Kenen and Rodrik 1986; Caballero and Corbo

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