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Trade intensity and purchasing power parity

Dooyeon Cho and Antonio Doblas-Madrid

Journal of International Economics, 2014, vol. 93, issue 1, 194-209

Abstract: In this paper, we seek to contribute to the PPP literature by presenting evidence of a link between trade intensity and exchange rate dynamics. We first establish a negative effect of trade intensity on exchange rate volatility using panel regressions, with distance as an instrument to correct for endogeneity. We also estimate a nonlinear model of mean reversion to compute half-lives of deviations of bilateral exchange rates from the levels dictated by relative PPP, and find these half-lives to be significantly shorter for high trade intensity currency pairs. This result does not appear to be driven by Central Bank intervention. Finally, we show that conditioning on PPP may help improve the performance of popular currency trading strategies, such as the carry trade, especially for low trade intensity currency pairs.

Keywords: Trade intensity; Deviations from PPP; Exchange rate volatility; Carry trades; Mean reversion (search for similar items in EconPapers)
JEL-codes: C13 C52 F31 F47 (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1016/j.jinteco.2014.01.007

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