2 nd INTERNATIONAL CONFERENCE ON BUSINESS AND ECONOMIC RESEARCH (2 nd ICBER 2011) PROCEEDING 1784 EXCHANGE RATE RISK AND TRADE FLOWS: A GRAVITY EQUATION APPROACH Akram Shavkatovich Hasanov Faculty of Economics and Management, Universiti Putra Malaysia Ahmad Zubaidi Baharumshah Graduate School of Management and Faculty of Economics and Management, Universiti Putra Malaysia Mahendran Shitan, Laboratory of Computational Statistics and Operations Research, Institute for Mathematical Research, Universiti Putra Malaysia and Department of Mathematics, Faculty of Science, Universiti Putra Malaysia Zainidin Karimovich Eshkuvatov Department of Mathematics, Faculty of Science, Universiti Putra Malaysia and Institute for Mathematical Research, Universiti Putra Malaysia. Abstract This study attempts to examine the effects of exchange rate risk on aggregate bilateral trade flows employing gravity models for Kazakhstan. The empirical analysis uses the quarterly data for the period from 1995(quarter 3) to 2008(quarter 4). In this study, the gravity models have been estimated which is perceived as the better model in predicting the bilateral trade between countries i and j using the panel data techniques. Specifically, this study provides the estimation results for the gravity equation incorporating the following main determinants: distance between Kazakhstan and potential trade partners, product of incomes of trading countries, product of incomes per capita, bilateral exchange rate risk, dummy for the common border, and dummy for the common language. For the measure of exchange rate risk, this study estimated various GARCH family models assuming various distribution hypotheses and selected the best-fitted model relying on forecasting performance. The estimation results indicate that gravity models better explain the bilateral trade between Kazakhstan and potential trading partners. For the country under investigation, ten potential trading partners are selected using the data provided in Directions of Trade (DOT) database of International Monetary Fund (IMF). Our findings are summarized as follows. Firstly, Kazakh trade with potential trading countries is discouraged by exchange rate risk during de facto floating exchange rate regime. Secondly, for the full sample period, the effect of exchange rate risk on bilateral trade is found to be ambiguous.