Integrated Exchange Rate Model

Integrated Exchange Rate Model (IERM) &  Working Capital Management.  Case: Russian Rouble & Euro  (Draft Version October 24th 2010) 


With the transportation of goods over long distances not just goods but also an inventory is being shipped. The value of this inventory could change due to the fluctuations in the exchange rates of the involved (international) currencies. This article introduces an integrated exchange rate model to help shippers and transporters with this aspect.

Table of content 

Introduction; Markets for exchange rates; The integrated exchange rate model; Central banks; Interest rate differentials; Inflation rate differentials; Balance of payments; Psychological and political influences; Exchange rate exposure on firm level; Case study: Working capital management in logistics


In this article the five fundamental forces of exchange rate determination will be discussed in a non-mathematical way; so entrepreneurs can make a qualitative forecast for their decisions to hedge exchange rate exposures.

The integrated exchange rate model (IERM) consists of five fundamental forces:

I.        Central banks

II.        Interest rate differentials

III.       Inflation rate differentials

IV.        Balance of payments

V.        Psychological and political influences

Central Banks play an important role in the exchange rate determination; they can have direct intervention (buying / selling foreign currencies to back up their domestic currency) and /or indirect intervention (influencing the national short interest rate structures; because of that influencing the short term international interest differential; and thus influencing short term capital inflow and outflows).

Interest rate differentials are a driving factor of capital flows between countries (Capital account of the balance of payments). Suppose the interest rate on the capital market of the €euro region increases (ceteris paribus the interest rates in the USA and the rest of the world); there might be an inflow of foreign currencies to the €urozone (so more demand for €uro’s in the USA and more supply of US $’s in the €urozone).

Inflation rate differentials have always had a fundamental / underlying role in the long term development of exchange rates; The well known Big Mac Index (published by the Economist) gives us insight in the fundamental external currency value. In general countries with a high inflation percentage; have also a weak exchange rate.

Balance of payments are traditional important to explain exchange rates, we distinguish the current account (for import and export of goods, services and income transfers) and the capital account (for export and import of capital). So money flows between countries have a tremendous influence of the price of currencies (eg exchange rate). Underlying factors of the current account are the national business cycles and the competiveness of countries à la Michael Porter. The capital account of the balance of payments is dealt with the short and long term capital movements, caused by international interest rate differentials.

Psychological and political influences are in the very short term of quite dominant influence on the exchange rates of currencies. Mass behaviour based on self fulfilling prophecies are sometimes based on non-rational behaviour; and can cause quite important distortions on the currency markets. It is well known that monetary authorities have a strong reason for having international meetings on Saturdays and Sundays; to not influence the markets.

Exchange rate exposure is an important part of daily business risk for companies active in the global economy. Every enterprise is nowadays (direct or indirect) connected to international supply chains; so from costs (input) and revenues (output) the company’s value chain is exposed to currency risks. In an operational way this is part of the working capital management [1] of the company; object of this article is to optimise the use of working capital management in an international business environment .

Markets for exchange rates

An exchange rate is in fact a price for a foreign currency expressed in an domestic currency,  so on the currency exchanges in Frankfurt (€urozone) and Moscow(Russia) we can observe the exchange rates CNY/US $ and US $ / CNY:

   Frankfurt (RUB / € 1 )   Moscow  ( € / RUB 1 ) 
May 7th 2010    38.98     0,025654 

Table 1: Exchange rates of the RUB and the €uro  (Source:

In terms of supply and demand graphs the markets are cleared, when supply and demand intersect; and thus the exchange rates are established in the equilibrium.

The both graphs for the currency markets in Frankfurt (for the RUB) and Moscow (for the €) show this.

Figure 1: Currency Markets in Frankfurt and Moscow

The demand for a foreign currency depends in fact of the two main balances of the balance of payments: Current Account and Capital Account.  So the import of goods and services (Current Account) and the export of domestic capital to foreign investment opportunities (Capital Account); cause a demand for foreign currencies.

Mutatis mutandis the supply for a foreign currency depends on export of goods and services (Current Account) and the import of foreign capital for domestic  investment opportunities (Capital Account); cause a supply for foreign currencies.

In the last section of this article we will have a more look in detail at the balances of payments of the €urozone and Russia; so we might give a forecast of a certain exchange rate development.

The integrated exchange rate model

The Integrated Exchange Rate Model (IERM) is a model of some mainstream theories in the field of international economics; explaining the (static) exchange rate determination on (spot) markets for currencies.

As a summary of those mainstream theories we distinguish five fundamental forces:

I.        Central banks

II.        Interest rate differentials

III.        Inflation rate differentials

IV.        Balance of payments

V.        Psychological and political influences

Also expressed in figure 2.

Figure 2: Integrated Exchange Rate Model

The ambition is to make exchange rate developments understandable for general interested user of exchange rate information; the underlying theoretical structures (without using mathematics; a tool economists often use).

The coming sections of this article will explain step by step the theoretical background of the five forces of the Integrated Exchange Rate Model.

The model is integrated , because all five forces are having a simultaneously influence on the exchange rate determination; sometimes one factor might be a dominant for explanation of exchange rate developments.

Central banks

Central Banks have in general two important goals:

  • Internal price stability [2]
  • External price stability [3]

To maintain internal (or domestic) price stability (CPI [4] ) central banks often use the short term interest rate instrument. When the central bank rises short term interest rates, banks will charge their clients a higher interest rate as well. Because of the higher interest rates consumers and enterprises will borrow less for consumption and investment; so aggregate (macroeconomic) demand will contract. As a result of the contraction of macroeconomics demand; prices in the economy will not increase that much (so the CPI will not increase that much anymore). This internal adaption process (via short term domestic interest rates)has of course influence on the international short interest rate differential. Assume no rise in short term international interest rates and a rise in domestic short term interest rates; this country will be more attractive for short term investments. And because of that the demand for this currency will increase; thus the exchange rate for this country will have a tendency to increase (ceteris paribus). The role of interest rates will also be explained in the section interest rate differentials.

In the IERM graph (figure 2) this effect is the dotted line from the monetary policy to the international money market developments (this is called the indirect effect).

The central bank can also decide to have currency intervention, to maintain a certain level of external price stability or exchange rate stability. Exchange rate stability is important for the development of international trade of a country and the rest of the world. IMF wants to prevent international chain reactions of devaluation / depreciation to improve international competitiveness [5] for one country.

A central bank can for instance sell foreign currencies (eg buy domestic currencies) to back up their weak domestic currency or to buy foreign currencies (eg sell domestic currencies) to lower pressure on their strong domestic currency (this is called the direct effect). Successful currency intervention depends very much on international co-ordination between central banks (and the IMF).

Interest rate differentials 

This section deals with the international capital flows on several financial markets; the capital market (for long run financial flows) and the money market (for short run financial flows). These financial flows are registered on the capital account and financial account of the balance of payments.

In the previous section the money market flows were already explained; as a result of interest rate policies of central banks. Beside central banks, the interbank bank markets play a dominant role for short term money flows in the world; the interbank market is a wholesale market for banks that have an excess liquidity and have an excess illiquidity.

Long term interest rates are composed of 3 basic factors:

  • Real interest rate
  • Inflation mark up
  • Risk mark up

The real interest rate is the basic interest rate in a world without inflation and without risk, in some economies this interest rate is about 2% or 2.5% for premium state bonds. Because of inflation and risk interest rate can be 10% or more. Capital market flows have a tendency to flow to the country with the highest (expected) real interest rate; so there will be a demand for this currency; and thus the exchange rate will increase of that currency. Sometimes also other arguments play an important role to invest in a safe haven economy; like political stability, a sound financial system and  of course reliable banks.

Inflation rate differentials

Inflation rate differentials have a long tradition in economic theory of explanation of exchange rates: Purchasing Power Parity (PPP) theory.

A popular variant of this PPP-theory can be find in the well know Big Mac Index from the Economist [6] from October 16th 2010 we can calculate the costs of a Big Mac in the USA (US $ 3.71) and in China (US $ 2.18). So the CNY is undervalued  of more than 40% to the US $ { (2.18 – 3.71) / 3.71 }.

Question now is this caused by inflation differences  between the USA and PRC?

In the Economist [7] from October 16th 2010 we can find some data:

   2009  2010(forecast)
Russia  10.7%  6.7%
€urozone  –0.3%  1.5%

Table 2: Inflation rates (CPI) (Source:

According to the PPP-theory Russia (6.7%) has more expected inflation than the €urozone (1.5%); so the CNY is expected to depreciate / devaluate with about 5.2% [8] (the difference in inflation rate tempi between Russia and the €urozone).

This is actually not what we should expect from the current situation of the RUB (compared to the €); so there is apparently another dominant explanation of the strong RUB hypothesis. This explanation will be provided in the section of this article: Balance of Payments.

Balance of payments

Russian exports a lot of energy to the €urzone and  imports from the €urozone consumer products and  equipment; the overall result for both trade blocks are indicated below in table 3.

  Trade balance(in Billion US $) Current Account(in Billion US $) Current Account(in % of GDP)
Russia +151.6 +84.2 +5.0
€urozone +12.9 -68.2 -0.5

Table 3: Balances of Payments (Source:

Also the Reserves of foreign exchange and gold [9] of both countries differ a lot: Russia

has  a value of  $ 439,000,000,000 (3rd  place) and the €urozone has a value of  about  € 546,000,000,000 (no listing on the CIA website).

So on the currency markets the RUB has a more strong position than €, because of high surplus on the balance of payments (current account) and the equal high level of international reserves; so from this perspective an appreciation / revaluation of the RUB (or a depreciation / devaluation of the € should be expected.

As we can observe now the 5 forces of the integrated exchange rate model are simultaneously playing their role on the exchange rate level; they can reinforce each other and/or be contrary.

The balance of payments of a country is in fact influenced by 2 fundamental causes:

  • The business cycle
  • The (global) competiveness)

In a (global) recession exports have a tendency to fall more stronger than the imports; so the current account of the balance of payments has a tendency to quite strong fall in the balance. So we observe rapidly growing deficits and/or rapidly lowering surpluses.

The current account is a  good yardstick for the strength of an economy in the global competition; if a company is flexible and competitive their potential competiveness is excellent in the global economy. So the country has also a (possible) potential surplus on their trade balance and/or current account.

Psychological and political influences

Psychological and political influences are especially relevant for explanations in the short run of the currency markets (and also other (financial) markets in the economy); speculative behaviour and the anticipation of that can cause huge distortions on currency markets (than the 4 other more fundamental forces).

Often an expected political announcement (made by the IMF, Central Banks and or other monetary authorities) cause positions (net-selling or net-buying) on currency markets; and because of that other participants are going to sell (or to buy) more. The effect on the exchange rate of the currency will be than quite strong decrease (or increase) because of self-fulfilling prophecies.

For this sort of irrational mass behaviour there is no rational explanation from economic theory; but it is still a realistic phenomenon occurring on financial markets all over the world. Often market authorities stop the trade in currencies to prevent high speculative behaviour and non-desired outcome of that.

Exchange rate exposure on firm level

 We distinguish 3 sorts of exchange rate exposures on company level:

  • Operational / Transaction exposure
  • Economic exposure
  • Translation exposure

Operational / Transaction exposure is linked to a contract to import (or to export) goods and services. Suppose an EU company imports components from Russia; and the contract is in RUB’s. Suppose we are talking about a full container load of technical components AR-500-Z for an amount of RUB 6,000,000 (CIF condition); the contract was established at May 7th  2010 and payment (after delivery in the EU) to be expected October 22nd  2010.

Suppose the EU company wants to have no exchange rate risk and decides to buy now (May 7th ) RUB 6,000,000 for an amount of € 153,926 (RUB 6,000,000 / RUB (per €) 38.98).

The cost of this hedge transaction is in terms of missed interest: 165 days (month  = 30 days) @ 2.9% PA (assumption interest rate in USA); so in opportunity costs:

€ 205.

Of course there are other hedge instruments like currency options and currency futures.

Looking backwards (after completing the transaction on October 22nd ) the costs of the transactions are € 141.341  ( RUB 6,000,000 / RUB(per €) 42.4508); but the EU company did not know this exchange rate on May 7th  .

Economic exposure provides the company to make choices because of changes in prices of imported products and services; in running contracts (operational exposure) it is impossible to adapt and the company has to accept the outcome in terms of costs and benefits. The adaption can show a lot scenarios:

  • Accept increased cost in local currencies and:
    • lower the profit margin
    • maintain the profit margin and charge higher prices to clients
  • Look for cheaper suppliers
    • Abroad:
      • existing supplier
      • new supplier
      • Domestic supplier
  • Innovations of production and/or product resulting in cheaper costs

Translation or accounting exposure is not so relevant in this example; but for instance relevant in the case that the EU company would have a joint venture [10] with Russian company; and the EU company was going finance for instance a new production plant in Russia financed with EU capital (for instance issued with: new shares and new bonds). Value of the joint venture plant is a topic of study of translation exposure; especially when this Russian joint venture is consolidated (let us assume for 49%) in the annual report of the EU company.

Case study: Working capital management in logistics

The figures 3 and 4 provide us with information over 6 months exchange rate development of the RUB and the €. The Bank of Russia  (The Central Bank of the Russian Federation uses a kind of currency board to determine foreign exchange rates; eg €) has a policy of fixed / managed exchange rate of the RUB towards the € and US $. As already stated in sections inflation rate differentials and balance of payments the RUB seems to be undervalued to the €  or the € is overvalued to theRUB.

Figure 3: Exchange rate € per RUB 1

Figure 4: Exchange rate RUB per € 1

In table 2 the moments are summarised (May 17th  and October 22nd) and the relative change (% ∆)  of the exchange rates

    RUB / € 1   € / RUB 1 
May 7th 2010   38.98  0,025654
Oct 22nd2010   42.4508  0,023556
% ∆   +8.9%  -8.2%

Table 4: Exchange rates of the RUB and the € (Source:

So what does this mean for business operations at company level? Suppose we are €urozone  company (from the previous section) importing components AR-500-Z for an amount of RUB 6,000,000 (CIF condition) from Russia.

Table 5 provides  a summary of activities concerning the import of component AR-500-Z .

Table 5: Overview of activities of importing component AR-500-Z

We can distinguish a few risks:

  • Currency risk
  • Price risk of inventory during the pipeline time
  • Quality risk of components delivered
  • Transport risks (for instance damage)
  • Legal risks (for instants permit to export or to import; health certificate; certificate of safety & quality standard; etc.)
  • Payment risk (reliable banks)

In the focus of this article; the currency risk is quite obvious to study more closer and how to deal with this risk (hedging).

As already stated in the previous section the EU company made a choice to buy RUB in advance and to have no speculative position (ex post not so interesting, because the exchange rate dropped). Let us sum up the possible strategies for a company importing goods from another currency area :

  • Buy foreign currency in advance
  • Buy a call currency option ( a right to buy in this case RUB and to pay with €)
  • Buy currency futures ( an obligation to buy in this case RUB and to pay with €
  • Netting flows of incoming and outgoing RUB’s  in the company or with another (EU) company
  • Barter trade between Russian and €uro-zone company (eventually with more companies to clear positions)
  • No hedging actions, just accept the currency risk.

Also the different policies we can distinguish (from above) have their price; we calculated already the opportunity costs of € 205 in the previous section of buying foreign currency in advance. Buying options and futures are of course also not for free and you have to include transactions costs  as well. Netting and barter trade often involve a lot of time (and so costs) to clear positions.

So you have really to make a good trade off of all costs involved (including time related costs) and to cover a certain risk. By not covering a position you have of course serious exposure to risks, but also no costs! So you might reserve amounts of money on a special provisions account; as a kind of internal hediging strategy.

Also buying foreign currency in advance is a very transparent strategy, where at least you in advance what your costs are of the purchases. Also this a very transparent strategy, especial as most SME’s do not have specialised treasure departments. For MNE’s (with specialised treasury departments) the scenarios are of course more open to more complicated hedge strategies with currency options, currency futures, (internal) netting and (internal) barter trade. 

Jan Jansen, Velp, Netherlands





De Roos

[1] Working Capital: Accounts Receivables + Inventory + Net Cash Position  – Accounts Payable

[2] Often called inflation / deflation and measured by the CPI (Conusmer Price Index)

[3] No fluctuations in the national exchange rate (depreciation / appreciation under flexible exchange rates or devaluation / revaluation under fixed exchange rates)

[4] CPI = Consumer Price Index

[5] Article I, Sub iii: To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.( Articles of Agreement of the International Monetary Fund;



[8] The exact calculation is: 1,067 / 1.015 = 1.05123 or 5.123 %)

[9] Source:

[10] Or a merge or an acquisition


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