Currency Invoicing: The Role of ‘Herding’ and Exchange Rate Volatility

Abstract

This paper analyzes an individual firm's choice of invoicing currency under exchange rate volatility. Greater exchange rate volatility amplifies the representative firm's desire to ‘herd’ relative to all other considerations that may affect the currency denomination decision. By ‘herding’ a firm chooses a currency of denomination so that the firm's price and the competition's price are affected by the exchange rate in a similar manner. Contrary to previous research, the results herein suggest that individual firms may invoice in a relatively volatile currency as long as its competitor's invoice in the same volatile currency.

Keywords:

• Currency invoicing
• exchange rate
• vehicle currency
• price adjustment
• menu costs

Notes

¹This is the case in the US as exporters to the US tend to use LCP.

²Such is the case in East Asian economies where PCP and VCP are prevalent.

³Friberg (1998), Bacchetta and van Wincoop (2005), Devereux et al. (2004), Floden and Wilander (2006).

⁴Details on these developments can be found at the following websites: http://www.bloomberg.com/apps/news?pid=20601086&refer=latin_america&sid=aGBuWpZJ9cPI, http://www.bloomberg.com/apps/news?pid=20601080&sid=aqA9QhRSNeqM, http://www.bloomberg.com/apps/news?pid=20601087&sid=aSTmuCr.RD88, http://online.wsj.com/article/BT-CO-20090629-707133.html.

⁵Goldberg and Tille (2005) use the term ‘herding’ based on the expected basket of currencies that may affect the targeted price index. Fukuda and Ono (2006) refer to this effect as the ‘history’ of currency denomination choices. The history of previous currency denomination decisions creates the expectation of currency invoicing weights in Goldberg and Tille's basket.

⁶Empirical evidence of an endogenous frequency of price adjustment is given in recent work by Gopinath and Rigobon (2008), which shows that a wide range of frequencies of price adjustment are found in US trade flows.

⁷This model chooses to use a partial equilibrium, as opposed to a general equilibrium analysis. In a general equilibrium model it is necessary to have underlying forms that may not be empirically justifiable for variables that firms may inevitably consider exogenous (such as exchange rates). Among others, Goldberg and Tille (2008, p. 179) also choose to avoid a general equilibrium setup with similar justification.

⁸By setting their price, the firm also sets their input quantity and output quantity.

⁹In the numerical simulation outlined in the Appendix, the optimality of invoicing currency, frequency of price adjustment and forward contract use is determined by the maximum profits computer-generated under each of the discrete choices.

¹⁰This is similar to the menu cost used in Devereux and Yetman (2005).

¹¹This is as Choudhri et al. (2005) would promote.

¹²The ‘herd’ of firms already using currency j generate the large pass-through coefficient of currency j in the importing country i.

¹³SUR is not often used with dichotomous variables, although any bias created from its use here would not impact sign and significance. Given the theoretical nature of the range in the underlying exogenous variables it is unlikely that perfectly accurate point estimations will be useful.

¹⁴During the height of the financial crisis in the Fall of 2008 the average intra-European exchange rate was roughly six times more volatile than in the six months prior.