CFA Level I Exam · Capital Flows and the FX Market

Foreign Exchange Market Basics for CFA Level I

Updated 7 October 2026 · Fact-checked

The FX market is a global, mostly over-the-counter market where currencies are exchanged. Participants split into the sell side (dealers) and the buy side (corporations, funds, governments, central banks). Main instruments are spot (settles in about two business days), forwards (settle on a later date at a fixed rate) and FX swaps (a spot plus an opposite forward).

Understand Foreign Exchange Market Basics

The foreign exchange (FX) market is where one currency is exchanged for another. It is the largest financial market by turnover. It has no single location. Most trading is over the counter (OTC), done by phone or electronic platforms between dealers and clients, though some currency futures trade on exchanges.

Participants fall into two groups. The sell side is made up of large banks and dealers that quote prices and make markets. The buy side is made up of corporations, real money accounts (mutual funds, pension funds, insurers, sovereign wealth funds), leveraged accounts (hedge funds, proprietary traders), governments and government-sponsored entities, central banks, retail investors, and other users. Buy-side firms trade with dealers, and dealers trade with each other in the interbank market.

People use the market for different reasons. Corporations pay for imports, receive export revenue and hedge future currency cash flows. Investors buy foreign assets and need the local currency. Central banks may intervene to influence their currency or manage reserves. Speculators take views on currency direction. Whatever the motive, the mechanics do not change: every trade is one currency bought and another sold.

The spot transaction is for immediate exchange at the current rate. Settlement is usually two business days after the trade date (T+2). Some pairs settle sooner, for example USD/CAD at T+1. A forward contract fixes today a rate for exchange on a future date, beyond spot settlement. It is a customised OTC agreement. An FX swap combines two opposite exchanges: for example buy a currency spot and sell it forward. It is used to roll or fund positions and to adjust the settlement date of an exposure without taking on net currency risk. Do not confuse an FX swap with a currency swap, which exchanges interest payments over several years.

A non-deliverable forward (NDF) is a forward where no currency is delivered at maturity. The parties settle the gain or loss in a freely traded currency, usually USD, based on the difference between the contract rate and the spot rate at maturity. NDFs are used for currencies with capital controls or limited convertibility.

Key formulas to remember

Spot settlement convention: Settlement date = trade date + 2 business days (T+2) for most pairs; Exceptions exist, such as USD/CAD at T+1. A forward has settlement later than spot.
Forward contract settlement: Forward = exchange at a rate fixed today for a date later than spot; The rate is the forward rate, set from the spot rate and interest rate differentials.
FX swap structure: FX swap = spot (or near-leg) exchange + opposite exchange on a later date; Net currency exposure is roughly zero. It is not the same as a currency swap.
NDF settlement amount (cash-settled): For a USD/XXX quote (XXX per 1 USD) with the notional in USD, the party long USD receives: notional × (spot at maturity − NDF rate) ÷ spot at maturity, paid in USD; The gain is first found in the price currency (XXX) as notional × (spot − NDF rate), then converted to USD at the maturity spot rate, which is why you divide by spot. A negative value means the party long USD pays that amount to the other party. The party short USD receives the opposite amount. For any other quote, say which currency is the price currency, compute the gain in that currency, then convert it to the settlement currency at spot. Always check the quote direction first.
Market participants: Sell side = dealers/banks; Buy side = corporations, real money, leveraged accounts, governments, central banks, retail; Know which group each participant belongs to.

How to solve Foreign Exchange Market Basics questions

Use this method for any conceptual or calculation question on FX market basics.

1Identify what the question asks: participant type, instrument, settlement timing or a payoff.
2Classify any named party as sell side or buy side. Banks quoting prices are sell side; everyone who uses those quotes is buy side.
3Identify the instrument: spot (T+2 usually), forward (later date, fixed rate), FX swap (two opposite legs) or NDF (cash settled, no delivery).
4For timing questions, count business days from the trade date and skip weekends.
5For payoff questions, write the quote direction first (price currency per base currency), then compute the gain or loss on the notional.
6Check whether the motive is hedging, speculation, investment funding or intervention, and match it to the participant.
7Eliminate options that confuse FX swaps with currency swaps or forwards with spot, then choose the remaining option.

Quickest way: Match instrument to its defining feature

When to use it: Use this for conceptual three-option items where you have about 90 seconds.

Spot: immediate, T+2 usually.
Forward: customised, future date, fixed rate set today.
FX swap: two legs in opposite directions, used to roll or fund.
NDF: cash settled, used when the currency is restricted.
Banks making markets are sell side; all other users are buy side.
Discard any option that mixes these features.

Common mistakes in Foreign Exchange Market Basics

Treating an FX swap as a currency swap.
Both contain the word swap and involve two currencies.
Fix: An FX swap is a spot plus an opposite forward. A currency swap exchanges periodic interest and principal over years.
Classifying central banks or hedge funds as sell side.
Students assume any large institution is a dealer.
Fix: Sell side means dealer banks that quote prices. Central banks, hedge funds and corporations are buy side.
Assuming spot settles the same day.
The word spot suggests immediate delivery.
Fix: Most spot trades settle at T+2. Remember exceptions like USD/CAD at T+1.
Thinking an NDF involves delivery of currency.
Forwards normally deliver.
Fix: An NDF settles only the difference in cash, usually in USD.
Saying FX is an exchange-traded market.
Equity markets are exchange-based.
Fix: FX is mainly OTC. Only some currency futures trade on exchanges.

Worked examples

Example 1

A trade for a pair that settles at T+2 is made on Thursday. Weekends are non-business days and there are no holidays. On which day does spot settlement occur?

Show the solution

Trade date is Thursday.
Business day 1 is Friday.
Business day 2 is the following Monday, since Saturday and Sunday are skipped.

Answer: Monday.

Example 2

Part 1: A corporation expects to receive EUR 5,000,000 in six months and sells EUR forward against USD at 1.1000 USD per EUR. At maturity, spot is 1.0600 USD per EUR. Ignoring costs, how much more USD does the forward deliver than selling at spot? Part 2: Is the corporation sell side or buy side?

Show the solution

Part 1: Forward proceeds = 5,000,000 × 1.1000 = USD 5,500,000.
Spot proceeds at maturity = 5,000,000 × 1.0600 = USD 5,300,000.
Difference = 5,500,000 − 5,300,000 = USD 200,000.
This advantage arises only because spot at maturity turned out to be 1.0600. It is not known in advance. Had spot risen above 1.1000, the forward would have delivered less than spot.
Part 2: The corporation uses the dealer's quote to hedge, so it is a buy-side user. The dealer bank that quoted the forward is the sell side.

Answer: Part 1: The forward delivers USD 200,000 more than spot, but only in hindsight because spot ended at 1.0600. Part 2: The corporation is buy side; the dealer bank is sell side.

Exam tips

Expect conceptual items that ask you to classify a participant as sell side or buy side.
Read carefully for FX swap versus currency swap wording.
For date questions, count only business days and note the pair's convention.
Know that NDFs settle in cash and are used for restricted currencies.
With no penalty for wrong answers, never leave an item blank. Eliminate the clearly wrong options first.

Practice questions from Capital Flows and the FX Market

Foreign Exchange Market Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Foreign Exchange Market Basics: frequently asked questions

Who are the sell side and buy side in the FX market?

The sell side is the dealer banks that quote prices and make markets. The buy side includes corporations, real money accounts, leveraged accounts, governments, central banks and retail investors who trade with those dealers.

What is the difference between spot, forward and swap in FX?

A spot trade settles usually at T+2 at the current rate. A forward fixes a rate today for settlement on a later date. An FX swap pairs a spot exchange with an opposite forward exchange.

Is the FX market exchange-traded?

Mostly no. Most FX trading is over the counter between dealers and clients. A limited amount, such as currency futures, trades on exchanges.

Why do companies use FX forwards?

They lock in a rate for a known future payment or receipt. This removes uncertainty about the home-currency value of that cash flow.