Library/CFA (Chartered Financial Analyst)/ECONOMICS: CFA® Program Curriculum 2026 • LEVEL I • VOLUME 2/Learning Module 7 Capital Flows and the FX Market

Learning Module 7 Capital Flows and the FX Market

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FX Market Basics and Participants5 min

The foreign exchange (FX) market is the largest financial market globally and operates 24 hours on business days, connecting diverse participants ranging from central banks and sovereign wealth funds to retail accounts and high-frequency traders. Exchange rates are prices of one currency in terms of another and are quoted in market conventions (price currency and base currency). Nominal spot exchange rates are market prices used for transactions; real exchange rates adjust nominal rates by domestic and foreign price levels to reflect relative purchasing power. Purchasing power parity (PPP) is a long-run concept asserting nominal rates should adjust to equalize prices across countries, but real-world frictions (non-traded goods, transport costs, differentiated baskets) cause persistent deviations.

Market participants include sell-side banks (dealers/market makers) and buy-side clients (corporates, real-money investors, leveraged traders, central banks, SWFs, governments). The FX market has spot, outright forward, and swaps as major instrument types; swaps dominate turnover. Standardized three-letter ISO codes identify currencies. Quoting conventions vary, and commonly used pairs (USD/EUR, JPY/USD) follow market conventions; cross-rates between nonquoted pairs can be derived algebraically using available quotes and appropriate inversions.

Key Points

FX market is 24-hour and largest by daily turnover.
Nominal vs real exchange rates: real = nominal adjusted by price levels.
Participants: sell-side banks, corporates, real-money, leveraged traders, central banks, SWFs.
Major instruments: spot, forwards, swaps; swaps account for a large share of turnover.
Currency codes (ISO) and quoting conventions matter for interpreting moves.

Quotations, Cross-Rates, and Percent Changes5 min

Percent changes in exchange rates require careful identification of which currency is base and which is price currency; appreciation/depreciation depends on the quote convention and inversion yields different percentage magnitudes. Cross-rates let you compute a rate between two currencies not directly quoted by algebraically combining two quotes (and inverting when necessary). Market quotes typically have fixed decimal places (four for most pairs, two for yen). Converting between quote conventions and calculating percentage changes must be done carefully to avoid misinterpreting appreciation versus depreciation.

Key Points

Cross-rate calculation uses multiplication and inversion depending on quote conventions.
Spot quotes often to 4 decimals; yen to 2 decimals—scale matters.
Percentage appreciation depends on which currency is base; reciprocals give different percent values.
Triangular arbitrage removes inconsistent cross-rate pricing quickly.

Forward Markets and Covered Interest Parity5 min

Forwards allow contracting today for future delivery; forward points (swap points) are the difference between forward and spot, scaled to the spot quote's last decimal. Points are proportional to the interest rate differential and roughly proportional to time to maturity (adjusted by day-count conventions). Covered interest parity (CIP) is the arbitrage condition linking spot, forward, domestic and foreign risk-free rates: (1 + rd) = S_f/d (1 + rf) (1 / F_f/d). Rearranged, F = S * (1 + rf)/(1 + rd). The currency with higher interest rates will typically trade at a forward discount. Forward rates are poor, noisy predictors of future spot rates, but are robust arbitrage-implied prices in efficient markets.

Key Points

Forward points = forward rate minus spot, scaled; usually quoted in pips.
Covered interest parity links spot, forward, and interest rates; arbitrage enforces parity.
Higher interest rate currency tends to trade at forward discount (all else equal).
Day-count conventions (e.g., actual/360) and maturity length affect forward points.

Exchange Rate Regimes and Policy Trade-offs5 min

Exchange rate regimes range from no separate legal tender (dollarization, monetary unions) to currency boards, fixed parities, crawling pegs/bands, managed floats, and independent floats. There is no ideal regime: credible fixed rates plus open capital mobility conflict with independent monetary policy. Currency boards and dollarization can import credibility but remove policy flexibility; managed regimes attempt compromise but can invite speculative pressures if reserve backing or policy credibility is in doubt. Historical regimes include the classical gold standard, Bretton Woods fixed parities, and the post-1973 predominance of floating rates with occasional coordinated interventions (e.g., Plaza Accord).

Key Points

Regimes differ by convertibility, flexibility, and monetary independence.
Fixed regimes limit monetary policy; floats restore monetary autonomy but add volatility.
Currency boards legally back domestic currency with foreign reserves; dollarization uses another country's currency directly.
Managed interventions and coordinated policy actions have historical precedent.

Capital Flows, Trade Balance, and Capital Restrictions5 min

Trade deficits must be matched by capital account surpluses; capital flows are the primary determinant of short- to medium-term exchange rate movements, while trade flows matter more in the long run. Governments may impose capital controls to limit inflows or outflows for reasons including preventing capital flight, preserving monetary policy space, protecting strategic sectors, or redirecting savings. Controls can be temporary stabilizing tools but carry long-term costs in investor perceptions and market access. Historical examples (e.g., Malaysia 1998) illustrate mixed outcomes: controls can stabilize but may deter future long-term investment.

Key Points

Accounting identity: trade balance offsets capital flows; they move together.
Capital mobility amplifies FX responses to interest rate differentials and policy.
Capital controls can be taxes, reserve requirements, quotas, or prohibitions; effectiveness varies.
Policy choices about controls and exchange regimes create trade-offs between stability and policy independence.

Questions

Question 1

Which market participant category is primarily responsible for providing two-sided price quotes to clients in the interbank FX market?

Learning Module 7 Capital Flows and the FX Market

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