This paper examines the effect of exchange rate volatility for two small countries, Croatia and Cyprus, on aggregate exports during the period of first quarter of 1990 to first quarter of 2012. It is claimed by some researchers that exchange rate volatility causes a reduction on the overall level of trade. Empirical researchers often utilize the standard deviation of the moving average of the logarithm of the exchange rate as a measure of exchange rate fluctuation. In this study, we propose a new measure for volatility. Overall, our results suggest that there is a positive effect of volatility on exports of Croatia and Cyprus. 1. Introduction The relationship between exchange rate volatility and export flows has been studied in a large number of theoretical and empirical papers. The main notion, suggested by some theoretical models, is that a rise in exchange rate volatility increases uncertainty of profits on contracts denominated in foreign currency and force risk averse agents to redirect their activity to the lower risk home market. Other models suggest that higher levels of exchange rate movements offer greater opportunity for profit and therefore might lead to an increase in exports. Alternatively, some researchers have suggested that it is possible to offset potential unexpected movements of the exchange rate by investing at the forward market causing producers to be unaffected by movements of the exchange rate. These different ranges of results have been supported by a large variety of empirical studies causing the effects of exchange rate volatility on exports to be one of the most controversial topics of international trade. This paper aims to model the effects of exchange rate volatility for Croatia and Cyprus for which empirical evidence is both limited and ambiguous and to utilize a new measure of volatility which captures unexpected movements of the exchange rate. Overall, our results contribute to the existing literature in the following ways: first, our investigation has attempted to shed some light on a topic for which the empirical literature is ambiguous. Second, our investigation examines a sample which is comprised of two countries, Croatia and Cyprus, for which the empirical literature is limited. Third, we model the effects of exchange rate volatility on exports taking into account data sample properties such as unit roots and cointegration and estimate the results with the use of a recently developed method: the ARDL methodology. Fourth, in addition to the common measure of volatility (logarithm of the moving average of the
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