International Finance and Global Capital Markets
Domain 1 tests how money crosses borders: balance-of-payments accounting, the parity conditions that link interest rates and exchange rates, and the policy constraints that shape capital flows. Questions are applied rather than definitional - expect a quote, a rate differential, and a request to identify the arbitrage or the policy consequence, often with Korean data.
Parity conditions and the balance of payments
- The BOP identity holds by construction: current account + capital account + financial account + errors = 0. Korea's persistent current account surplus is matched by net financial outflows (reserve accumulation, pension and institutional offshore investment), so a surplus does not mechanically strengthen the won.
- Covered interest parity: F/S = (1 + i_KRW)/(1 + i_USD). Persistent deviations are the cross-currency basis, which widens when dollar funding is scarce.
- Uncovered interest parity claims the forward premium equals expected depreciation; empirically it fails (the forward premium puzzle), which is why carry trades earn returns and occasionally suffer sharp unwinds.
- The real exchange rate is the nominal rate adjusted by relative price levels; competitiveness tracks unit labour costs, not the won alone.
The policy trilemma
A fixed rate, an open capital account and independent monetary policy cannot coexist. Korea runs a floating rate with an open capital account, and manages the corners with macroprudential tools and smoothed intervention rather than capital controls.
Worked example
Spot USD/KRW 1,350; KRW rate 3.5%, USD rate 5.0%, one year. Fair forward = 1,350 × 1.035/1.05 = 1,330.7. A dealer quotes 1,345, so forward dollars are rich in won. Borrow KRW 1,350, buy USD 1 spot, invest at 5% for USD 1.05, sell the proceeds forward at 1,345 for KRW 1,412.25, repay KRW 1,397.25 - a riskless KRW 15 per dollar. Capital flows would push the quote back toward 1,330.7.
Traps that cost marks
Treating a current account surplus as a prediction of appreciation; reporting the forward premium with the wrong sign; confusing the market convention (KRW per USD) with a won-per-dollar inverse quote; assuming CIP holds exactly in stress.