Economics · Reading 18

Capital Flows and the FX Market

CFA Level I · Economics · Reading 18 · about 41 min

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What you'll learn

LOS 18.a Describe the FX market's functions and participants (sell side, buy side), distinguish nominal from real exchange rates, and calculate percentage changes in a currency's value.
LOS 18.b Describe exchange rate regimes from dollarization to independent floating, and explain how exchange rates affect trade and capital flows (balance of payments identity).
LOS 18.c Describe the common objectives of government restrictions on capital flows.

Module 18.1

The Foreign Exchange Market

This reading describes the foreign exchange market and its participants, how to read price/base quotes, spot and forward rates, the difference between nominal and real exchange rates, and how to calculate a currency's percentage change against another. It then covers the IMF's exchange rate regimes, how exchange rates and the balance of payments link trade and capital flows, and the objectives of capital restrictions.

LOS 18.a — The FX market: functions, participants, nominal vs real rates, percentage changes

Why the foreign exchange market exists

Currencies are exchanged for two broad reasons: to pay for goods and services bought across borders (trade flows) and to buy foreign real and financial assets (capital flows). The capital-flow side is much larger than the trade side.

A firm that already has an exposure to a foreign currency (for example, a receivable of CHF 8 million due in 60 days) can take an offsetting position, such as a forward contract to sell those francs. A position that reduces an existing currency risk is hedging. A position that creates or increases currency risk (for example, buying a currency forward only because the buyer expects it to rise) is speculating. Corporations, investment funds, banks and governments all do both.

Participants: sell side and buy side

Key concept

Group	Who	Notes
Sell side	Large multinational banks	The dealers in currencies and the originators of forward FX contracts
Buy side: corporations	Importers, exporters, multinationals	Buy and sell currencies for cross-border business; hedge future receipts and payments with forwards
Buy side: real money accounts	Mutual funds, pension funds, insurance companies and other institutional accounts	Restricted in their use of leverage
Buy side: leveraged accounts	Hedge funds, proprietary trading firms, other trading firms	Make substantial use of leverage, typically through derivatives
Buy side: governments	Governments, sovereign wealth funds, government pension funds, central banks	Transactional, investment or speculative needs; central banks may intervene to influence the exchange rate
Buy side: retail FX market	Households and relatively small institutions	Tourism, cross-border investment, speculative trading

Exam convention: real money accounts are accounts that do not use derivatives, and leveraged accounts are accounts that use them. Current practice: the dividing line is leverage. Many pension funds and insurers hedge currency exposure with FX forwards and are still real money accounts.

Reading an exchange rate quote

An exchange rate is the price of one currency in terms of another. Quotes are written as price currency / base currency: 0.9250 CHF/USD means one US dollar (the base currency, in the "denominator") costs 0.9250 Swiss francs (the price currency). Read "/" as "per".

From the viewpoint of an investor whose home currency is the price currency, a price/base quote is a direct quote; for an investor whose home currency is the base currency it is an indirect quote.
Inverting a quote swaps the roles: 0.9250 CHF/USD is the same as $1/0.9250 = 1.0811$ USD/CHF.
Treat the base currency as the item being priced and the price currency as the money it is priced in. A rise in the price/base rate means the item has become more expensive: the base currency has appreciated, and the price currency has lost purchasing power over the base country's goods.

Spot and forward rates

The spot exchange rate is for immediate delivery (for most currencies, settlement is two business days after the trade).
A forward exchange rate is agreed today for an exchange on a specified future date (30, 90, 180 days, one year, ...). A forward contract fixes the amounts of both currencies to be exchanged. Example: a company that will receive NZD 4 million in 90 days and sells them forward at 0.5520 EUR/NZD has locked in EUR 2.208 million.

Nominal and real exchange rates

The rate quoted in the market at a point in time is the nominal exchange rate. The real exchange rate adjusts the nominal rate for changes in the two countries' price levels since a base period, so it tracks the purchasing power of one currency over the other country's goods:

Key concept

real P/B rate = nominal P/B rate \times \frac{C P I _{base currency}}{C P I _{price currency}}

with both CPIs set to 100 in the base period. What moves the real P/B rate:

Change (other things equal)	Real P/B rate	Purchasing power of the price currency over base-country goods
Nominal P/B rate rises	Rises	Falls
Price level in the base-currency country rises	Rises	Falls
Price level in the price-currency country rises	Falls	Rises

If neither country's price level changes, the CPI ratio stays at 1 and the real rate moves exactly with the nominal rate. The difference between nominal and real rates therefore comes only from the ratio of the two price levels (relative inflation).

Example. Base period: both CPIs = 100 and the rate is 1.50 SGD/GBP (price currency SGD, base currency GBP). Two years later the nominal rate is 1.44 SGD/GBP, the UK CPI is 107 and the Singapore CPI is 104.

real SGD/GBP = 1.44 \times \frac{107}{104} = 1.4815

The nominal rate fell 4.0%, but faster UK inflation offset part of that, so the real rate fell only about 1.2% (from 1.50 to 1.4815). A Singapore resident gained less purchasing power over UK goods than the nominal move suggests.

For a quick estimate, work in percentage changes: the change in the real P/B rate is approximately the change in the nominal rate, plus inflation in the base-currency country, minus inflation in the price-currency country. In the example this gives $- 4.0% + 7.0% - 4.0% = - 1.0%$ , close to the exact $1.4815/1.50 - 1 = - 1.23%$ .

Percentage change in a currency's value

For a quote P/B, the percentage change in the base currency is simply

%Δ base = \frac{new P/B}{old P/B} - 1

To get the change in the price currency, first invert both quotes so that it becomes the base currency:

Key concept

%Δ price = \frac{1/ new P/B}{1/ old P/B} - 1 = \frac{old P/B}{new P/B} - 1

Example. The CHF/USD rate moves from 0.8000 to 0.8600. The USD (base) has appreciated by $0.8600/0.8000 - 1 = 7.50%$ . The CHF (price) has depreciated by $0.8000/0.8600 - 1 = - 6.98%$ . The two percentages differ in size.

When a currency buys more of a foreign currency (it has appreciated), foreign goods become cheaper for its residents, and the country's exports become more expensive for foreigners.

Common exam traps

Reading a rise in USD/EUR as a stronger dollar. The euro is the base currency, so a higher quote means the euro has appreciated.
Reusing the base currency's percentage change, with the sign flipped, for the price currency. Invert the quotes first; the two percentages differ. In the CHF/USD example, flipping the sign gives −7.50% for the franc instead of −6.98%.
Putting hedge funds or central banks on the sell side. The sell side is the large dealer banks; hedge funds and central banks are buy-side participants.
Forgetting that a currency forward is a derivative. An investor whose mandate bars derivatives cannot use one, even to hedge.
Adjusting a real exchange rate with interest rates, or putting the price country's CPI in the numerator. The base country's CPI goes on top. In the SGD/GBP example, $1.44 \times 104/107 = 1.3996$ instead of 1.4815.
Reading a pair in the market dealers' order. Dealers usually name the base currency first (EUR/USD 1.25 for 1.25 dollars per euro); the price/base form used here writes the same rate as 1.25 USD/EUR.

Exam shortcuts

In a price/base quote a higher number means the base currency (the denominator) has appreciated, so identify the base currency before judging which currency strengthened.
The percentage change in the real P/B rate is approximately the nominal change plus base-country inflation minus price-country inflation, a quick estimate that needs no CPI ratio.

Bottom line

The FX market serves trade flows and the much larger capital flows; a position that reduces an existing currency risk is hedging, and one that creates or increases currency risk is speculating.
The sell side is the large multinational dealer banks, and the buy side is corporations, real money and leveraged accounts, governments and central banks, and the retail market; the exam convention separates real money from leveraged accounts by derivatives use, while current practice separates them by leverage.
A P/B quote states how many units of the price currency buy one unit of the base currency, so a higher quote means the base currency has appreciated, and the quote is direct for an investor whose home currency is the price currency.
A spot rate is for immediate delivery (usually two business days), and a forward rate is agreed today for an exchange of fixed amounts on a specified future date.
The real P/B rate equals the nominal P/B rate × $C P I_{base} / C P I_{price}$ , so it rises with the nominal rate and the base-country price level and falls with the price-country price level.
The base currency changes by new P/B ÷ old P/B − 1 and the price currency by old P/B ÷ new P/B − 1, and the two percentages differ in size.

Quick check

Question 1Core

Buy-side participants in the foreign exchange market include real money accounts and leveraged accounts. Compared with a real money account, an investment account classified as a leveraged account is most likely distinguished by its:

Show answer and explanation

Correct answer: A

Leveraged accounts are investment firms such as hedge funds, proprietary trading firms and other trading firms that make substantial use of leverage, typically through derivatives. Real money accounts, such as mutual funds, pension funds, insurance companies and similar institutional accounts, are restricted in their use of leverage. Both are buy-side participants.

Why the other options are wrong

B. Quoting two-way prices is the role of the dealers on the sell side (large multinational banks). Leveraged accounts are buy-side clients of those dealers.
C. Being restricted to long-term, unleveraged holdings describes a real money account, the opposite of a leveraged account.

Key takeaway Leveraged accounts (hedge funds, trading firms) use leverage extensively, typically via derivatives; real money accounts (mutual funds, pension funds, insurers) are restricted in their use of leverage.

Module 18.2

Managing Exchange Rates

LOS 18.b — Exchange rate regimes and effects on trade and capital flows

The IMF's classification of regimes

The IMF lists nine regimes: two for countries that do not issue a currency of their own and seven for countries that do. Moving down the table, the monetary authority generally gains more room for independent monetary policy.

Key concept

Regime	Own currency?	How it works	Monetary policy independence
Formal dollarization	No	Uses another country's currency	None; the interest earned on the assets backing the currency goes to the issuing central bank
Monetary union	No	Several countries share one currency (e.g. euro area)	No national policy, but members share in setting the union's policy
Currency board arrangement	Yes	Explicit commitment to exchange domestic currency for a specified foreign currency at a fixed rate; domestic currency issued only when fully backed by foreign reserves	Essentially none (imports the anchor's inflation), some short-term room on interest rates; the board earns interest on its reserves
Conventional fixed peg arrangement	Yes	Pegged to a currency or basket within margins of ±1%; maintained by direct intervention (buying/selling FX) and indirect intervention (interest rate policy, FX regulation, persuasion)	More than a currency board, but constrained by the peg
Target zone (pegged exchange rates within horizontal bands)	Yes	Like a peg but with wider fixed bands, e.g. ±2% or more	More discretion than a conventional peg
Crawling peg	Yes	The peg rate is adjusted periodically, usually for inflation differences (passive crawling peg), or along a pre-announced path (active crawling peg, which can anchor inflation expectations)	Similar to a fixed peg
Management of exchange rates within crawling bands	Yes	The band around the central rate is widened over time; used to move from a fixed peg toward a floating rate when the authority lacks the credibility to float at once	Increases as the bands widen
Managed floating exchange rates	Yes	The authority reacts to indicators (balance of payments, inflation, employment) with no target rate or predetermined path; intervention may be direct or indirect. Trading partners may respond in ways that reduce stability	Considerable
Independently floating	Yes	Market-determined; intervention only to slow the rate of change and damp short-term swings, not to hit a target level	Full

A currency board differs from dollarization because the country still issues its own currency (fully backed), and it differs from a conventional peg because it is an explicit commitment to exchange domestic currency at a fixed rate, with the currency issued only when fully backed, rather than a peg that may move within a ±1% band.

Exchange rates, trade and capital flows

Because an appreciation makes imports cheaper and exports dearer, it also shifts trade volumes. If the USD/GBP rate falls (the dollar appreciates), US imports from the UK tend to rise and US exports to the UK tend to fall. These trade effects build up slowly.

The balance of payments requires that capital flows offset any imbalance in trade. A country with a trade deficit (imports > exports) must have a capital account surplus (foreigners buy more of its assets than its residents buy abroad), and a country with a trade surplus has a capital account deficit. The identity:

Key concept

(X - M) \equiv (S - I) + (T - G)

where $X - M$ = exports minus imports, $S - I$ = private saving minus investment in physical capital, and $T - G$ = tax revenue minus government spending.

A trade deficit means total domestic saving (private plus government) falls short of domestic investment; foreign capital fills the gap. At least one of the two gaps must then be negative: private saving below investment, a government budget deficit, or both.
A government budget deficit that is not covered by an excess of private saving over investment goes together with a trade deficit.

Example. Private saving 260, investment 300, tax revenue 180, government spending 205 (billions). $(S - I) + (T - G) = - 40 + (- 25) = - 65$ : a trade deficit of 65, matched by a capital account surplus of 65.

Timing. Capital flows adjust much faster than spending, saving and asset prices, so they dominate exchange rate moves in the short and intermediate term. Trade flows matter more over the long term.

Reducing a trade deficit

The identity shows what has to change for a trade deficit to shrink on a lasting basis: the right-hand side must rise. That means domestic spending must fall relative to income: a smaller government budget deficit (larger $T - G$ ) or more private saving relative to domestic investment (larger $S - I$ ). A bigger capital account surplus does not cure a trade deficit; it is the financing side of the same imbalance.

LOS 18.c — Objectives of capital restrictions

Key concept

Governments may limit capital flowing in, out, or both. Commonly cited objectives:

Reduce the volatility of domestic asset prices. Sudden outflows in a crisis can crash the prices of liquid holdings like equities and bonds, especially in small economies with large foreign holdings.
Maintain fixed exchange rates. Limiting capital flows makes an exchange rate target easier to defend, freeing monetary and fiscal policy for domestic goals.
Keep domestic interest rates low. If residents cannot move money abroad for higher yields, the central bank can keep rates low and run a more independent monetary policy.
Protect strategic industries (e.g. defense, telecommunications) from foreign ownership.

Capital restrictions act on flows of investment capital. Tariffs, quotas, voluntary export restraints and regional trading agreements are trade-policy tools that act on flows of goods and services.

Common exam traps

Confusing a crawling peg with crawling bands. In a crawling peg the central rate itself is adjusted; with crawling bands the band around it widens, as a step from a peg toward floating.
Assuming an independent float means no intervention at all. Intervention can still slow the rate of change; it just has no target level.
Capital controls aim to keep domestic interest rates low (not high).

Exam shortcuts

Because $(X - M) \equiv (S - I) + (T - G)$ , a trade deficit implies that private saving falls short of investment, the government runs a budget deficit, or both, and a larger capital account surplus cannot be the cure.

Bottom line

The IMF lists two regimes for countries without their own currency (formal dollarization and monetary union) and seven for countries with one, and moving toward floating generally gives more room for independent monetary policy.
A currency board explicitly commits to swap domestic currency for a named foreign currency at a fixed rate, issuing currency only when fully backed, while a conventional fixed peg allows ±1% margins and a target zone wider bands such as ±2%.
A crawling peg adjusts the peg rate itself, crawling bands widen the band over time as a step toward floating, managed floating reacts to indicators without a target rate, and an independent float uses intervention only to slow the rate of change.
A currency appreciation raises imports and cuts exports, but these trade effects build up slowly; capital flows dominate exchange rate moves in the short and intermediate term, and trade flows matter more in the long term.
Under $(X - M) \equiv (S - I) + (T - G)$ , a trade deficit is matched by a capital account surplus, and shrinking it on a lasting basis requires domestic spending to fall relative to income.
Capital restrictions aim to reduce the volatility of domestic asset prices, maintain fixed exchange rates, keep domestic interest rates low and protect strategic industries from foreign ownership.

Quick check

Question 2Core

Under Pelagia's monetary law, the monetary authority may issue Pelagian dinars only when each new dinar is fully matched by euro reserves, and it must exchange dinars for euros on demand at a fixed rate. The authority earns interest on the euro reserves it holds. The regime Pelagia operates is best classified as:

Show answer and explanation

Correct answer: A

Under a currency board arrangement the monetary authority commits to convert its own currency into one named foreign currency on demand at a fixed rate, and it may issue domestic currency only when every unit is backed by reserves of that foreign currency. The country keeps its own currency and earns interest on its reserves, but it gives up independent monetary policy and in effect imports the inflation rate of the anchor currency.

Why the other options are wrong

B. Under formal dollarization a country has no currency of its own; it uses another country's currency, and the interest earned on the assets backing that currency goes to the issuing central bank. Pelagia issues its own dinars and earns interest on its reserves.
C. A conventional fixed peg keeps the currency within a narrow band, about 1% either side of the target rate, through intervention and policy, without a rule that every unit of domestic currency be backed by foreign reserves. The monetary authority keeps more policy flexibility than under a currency board.

Key takeaway Currency board: the country has its own currency, fully backed by an anchor currency at a fixed rate; its reserves earn interest, and it has no independent monetary policy.

Practice Questions

Question 3Core

Tomas Riedl, an economist in Lorvania, tracks the real exchange rate of the Lorvanian crown against its main trading partner's currency, quoted as the number of crowns needed to buy one unit of the partner's currency (domestic/foreign). Holding all other factors constant, which of the following would cause this real exchange rate to fall?

Show answer and explanation

Correct answer: C

The real domestic/foreign rate equals the nominal domestic/foreign rate multiplied by $C P I_{foreign} / C P I_{domestic}$ . The domestic price level sits in the denominator, so an increase in it lowers the real exchange rate and raises the purchasing power of the domestic currency over foreign goods.

real D/F = nominal D/F \times \frac{C P I _{F}}{C P I _{D}}

Here D (the domestic currency) is the price currency and F is the base currency. Raising $C P I_{D}$ shrinks the ratio, so the real rate falls; raising $C P I_{F}$ or the nominal rate increases it.

Why the other options are wrong

A. A higher foreign price level raises the real rate: foreign goods become more expensive relative to domestic goods, so the domestic currency loses purchasing power over foreign goods.
B. The real rate equals the nominal rate times a price-level ratio, so a higher nominal domestic/foreign rate raises the real rate, other things equal.

Key takeaway In the real P/B formula the base-country CPI is on top and the price-country CPI is on the bottom. Other things equal, a higher price level in the price-currency country lowers the real rate, while a higher base-country price level or a higher nominal rate raises it.

Question 4Core

Which of the following is least likely to be cited by a government as an objective of restricting capital flows?

Show answer and explanation

Correct answer: C

A commonly cited objective of capital restrictions is to keep domestic interest rates low, not high. When residents cannot move funds abroad to chase higher yields, the central bank can keep rates low and run a more independent monetary policy. Maintaining fixed exchange rates and protecting strategic industries are also standard objectives.

Why the other options are wrong

A. Limiting capital flows makes an exchange rate target easier to defend, so this is a standard objective.
B. Governments often bar foreign investment in sectors such as defense and telecommunications, so this is a standard objective.

Key takeaway Capital controls let a country keep domestic rates low while defending its exchange rate.

This reading has 31 questions in the full bank. Practice all of them.

Key Takeaways

Leveraged accounts (hedge funds, trading firms) use leverage extensively, typically via derivatives; real money accounts (mutual funds, pension funds, insurers) are restricted in their use of leverage.
In the real P/B formula the base-country CPI is on top and the price-country CPI is on the bottom. Other things equal, a higher price level in the price-currency country lowers the real rate, while a higher base-country price level or a higher nominal rate raises it.
Currency board: the country has its own currency, fully backed by an anchor currency at a fixed rate; its reserves earn interest, and it has no independent monetary policy.
Capital controls let a country keep domestic rates low while defending its exchange rate.