Exchange Rate Volatility with Third-Country Risk Impact: A Bilateral Analysis of Pakistan with Major Trading Partners

Abstract

A large body of literature has examined the impact of real exchange rate fluctuation on trade flows. Most of the studies report both positive and negative impact of exchange rate fluctuations on trade flows. In recent years, many studies point to the fact that third-country exchange rate risk also plays a vital role in affecting trade flows. Thus, this study aims to investigate the impact of bilateral exchange rate movements as well as third-country exchange rate risk on trade flows of Pakistan vis-à-vis her major trading partners. Hence all the previous studies provide country specific results, thus this research contributes by capturing real exchange rate and third country volatility effects by including major trading partners. The study employs the Autoregressive Distributed Lag Bounds testing Approach to co integration. This piece of research work finds significant evidence of the real exchange rate volatility and the third-country risk impacts. The results point to the fact that when evaluating the implications of bilateral exchange rate uncertainty on bilateral trade flows, the third country exchange rate risk also needs to be taken into consideration.