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CFA® Level I · Economics · free lesson
Capital Flows and the FX Market
Every cross-border investment carries currency risk, and exchange rate moves can add to or wipe out the return on a foreign asset. This module describes the foreign exchange market and its participants, the difference between nominal and real exchange rates, the range of exchange rate regimes and the trade-offs they impose, how currency moves affect the trade balance, and why capital flows can be both a benefit and a danger, leading some governments to restrict them.
What you will learn
1. Describe the functions of the foreign exchange market, its main instruments and the roles of its participants.
- FX turnover is about USD 9.6 trillion a day (BIS, April 2025); the US dollar is on one side of about 89% of trades.
- Functions: settling trade and investment, hedging and speculation.
- Instruments: spot (usually T+2), forwards, FX swaps, futures and options.
- Sell side = dealer banks; buy side = corporations, real money and leveraged accounts, retail, official sector.
- Hedgers reduce existing exposures; speculators take on exposure for profit.
2. Distinguish nominal from real exchange rates, and calculate and interpret changes in the real exchange rate.
- Nominal rate S(d/f): domestic currency units per foreign unit; a rise means domestic depreciation.
- Real rate q(d/f) = S(d/f) x P_f / P_d: relative price of foreign goods in a common currency.
- A rise in q(d/f) is a real depreciation of the domestic currency and improves competitiveness.
- Percentage change: %Δq ≈ %ΔS + foreign inflation - domestic inflation.
- Higher domestic inflation requires nominal depreciation just to keep the real rate stable.
3. Describe the main exchange rate regimes, from dollarization to independent floating, and explain the trade-offs among fixed exchange rates, free capital flows and independent monetary policy.
- Regimes run from dollarization and monetary union through currency boards and pegs to managed and independent floats.
- A currency board fully backs the monetary base with reserves at a fixed rate.
- Crawling pegs adjust parity periodically, often for inflation differences.
- Impossible trinity: choose two of fixed rate, free capital flows and independent monetary policy.
- Pegs import the anchor's policy and credibility but can face speculative attacks.
4. Explain how exchange rate changes affect the trade balance using the elasticities approach, the Marshall-Lerner condition, the J-curve and the absorption approach.
- Depreciation raises import costs and lowers foreign prices of exports; the effect depends on elasticities.
- Marshall-Lerner: ωX εX + ωM(εM - 1) > 0 for a depreciation to improve the balance.
- The bigger the initial deficit, the more elastic imports must be.
- J-curve: the balance worsens first, then improves as volumes adjust.
- Absorption approach: the balance improves only if income rises relative to domestic spending.
5. Describe the types, benefits and risks of international capital flows, and explain the objectives and forms of capital restrictions imposed by governments.
- Capital flows: FDI (stable), portfolio investment and short-term bank flows (volatile).
- Benefits: investment finance, technology transfer, diversification.
- Risks: credit and asset bubbles, sudden stops, currency mismatches.
- Objectives of controls: reduce volatility, defend an exchange rate regime, keep policy independence, protect strategic sectors, preserve reserves.
- Forms: inflow taxes, unremunerated reserve requirements, holding periods, ownership limits, outflow restrictions.
Module at a glance
- FX turnover is about USD 9.6 trillion a day; the US dollar is on one side of about 89% of trades.
- Participants: dealer banks (sell side); corporations, real money, leveraged accounts, retail and the official sector (buy side).
- Real exchange rate q(d/f) = S(d/f) x P_f / P_d; a rise is a real depreciation of the domestic currency.
- Regimes run from dollarization and currency boards through pegs to floats.
- Impossible trinity: a fixed rate, free capital flows and independent monetary policy cannot coexist.
- Marshall-Lerner: ωX εX + ωM(εM - 1) > 0; the J-curve shows early worsening.
- Absorption approach: the trade balance improves only if income rises relative to spending.
- Capital controls aim to curb volatility, defend regimes and preserve policy room, at the cost of distortions.
This free module has 5 lessons, 13 practice questions with full explanations.