Currency Risk Premia and Exporter Dynamics

We propose a novel mechanism to explain the incomplete pass-through of exchange rates to exporter prices and quantities, based on the relationship between exporters' dynamic pricing strategies and currency risk premia. When domestic currency risk premium increases, the relative value of current foreign currency cash flows rises compared to future ones. Consequently, exporters who set prices in customer markets are inclined to increase markups today, leading to higher prices in response to elevated risk premia. This risk-based explanation provides a new perspective on the exchange rate disconnect puzzle, suggesting that a higher currency risk premium dampens the direct impact of exchange rate changes on export prices. We test this mechanism empirically using firm-product level data from Colombian exporters on prices and quantities.