Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Economics (CFA Level I)/Capital Flows and the FX Market

Capital Flows and the FX Market

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Foreign Exchange Market Basics5 min

The Foreign Exchange (FX) market facilitates the trading of currencies using specific rate definitions. A spot exchange rate applies to immediate delivery (typically T+2), while a forward rate applies to transactions at a future date. The real exchange rate adjusts the nominal rate for inflation differentials using the formula: Real Rate = Nominal Rate x (Foreign CPI / Domestic CPI). Rates are quoted as Price Currency / Base Currency. For example, in a USD/EUR quote of 1.10, EUR is the base currency and USD is the price currency. If the rate rises, the base currency appreciates; if it falls, the base currency depreciates.

Key Points

Spot rates are for immediate delivery; Forward rates are for future delivery.
Real exchange rate adjusts nominal rates for relative purchasing power (CPI).
In a quote A/B, B is the base currency and A is the price currency.
Base currency appreciation is calculated as (New Rate / Old Rate) - 1.

Market Participants4 min

Market participants are divided into three main categories. The 'Sell Side' consists of large money center banks (e.g., Deutsche Bank, Citi) and smaller banks that provide liquidity. The 'Buy Side' includes corporate accounts (for trade), real money accounts (institutional investors like mutual funds), leveraged accounts (hedge funds, proprietary trading firms), and retail accounts. The 'Public Sector' involves governments, central banks, and sovereign wealth funds (SWFs), which often intervene for policy reasons rather than profit.

Key Points

Sell Side: Dealing banks providing liquidity.
Buy Side: Corporations, institutional investors, hedge funds, and retail.
Public Sector: Central banks and governments influencing policy.
Leveraged accounts include high-frequency algorithmic traders.

Exchange Rate Regimes6 min

Countries adopt different regimes to manage their currency. Some forgo their own currency through dollarization or monetary unions. Those issuing their own currency may use a Currency Board (legislated fixed exchange commitment), a Conventional Fixed Peg (pegged within +/- 1 percent), or a Peg with Horizontal Bands (wider margins, e.g., +/- 2 percent). Crawling Pegs adjust periodically for inflation. Managed Floating allows authority intervention without a specific target path, while Independently Floating rates are market-determined with intervention only to smooth volatility.

Key Points

Currency Board: Rigid, legislated commitment to exchange domestic currency for foreign currency at a fixed rate.
Crawling Peg: Adjusts specifically for higher inflation vs. the peg currency.
Managed Floating: Authority influences rate but without a published target.
Independent Floating: Market forces drive the rate.

Capital Restrictions and Trade Balance4 min

Governments may restrict capital flows to protect infant industries or for national security, though these measures are often criticized for inefficiency. The Balance of Trade is analyzed using the Absorption Approach, which states that the Balance of Trade equals National Income minus Total Expenditure. A surplus occurs when income exceeds expenditure, while a deficit occurs when expenditure exceeds income.

Key Points

Infant industry and national security are common arguments for capital restrictions.
Absorption Approach: Trade Balance = National Income - Total Expenditure.
Excess domestic demand (Expenditure > Income) leads to a trade deficit.

Questions

Question 1

In the context of foreign exchange quotes, if a rate is expressed as 1.25 USD/EUR, which currency is the base currency?

Capital Flows and the FX Market

Questions

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