Foreign Exchange Derivatives and International Trade in China

Abstract

Our paper studies the effect of foreign exchange derivatives on international trade in China theoretically and empirically. On one hand, we build a two-stage model of an international Cournot duopoly under exchange rate uncertainty, which extends the model of Broll et al (2009). Our extended model shows foreign exchange derivatives hedging exchange rate risk have the positive effects on export and import level of the firm if the von Neumann-Morgenstern utility function of the firm displays either constant or decreasing absolute risk aversion and the derivatives market is unbiased. On the other hand, we use Bayesian Vector Autoregression (BVAR) model with China’s monthly data over the period from Oct 2006 to Dec 2014, and the empirical results are consistent with what the theoretical model predicts.