FRM Exam Part I · Foreign Exchange Markets

Balance of Payments and Exchange Rate Regimes for FRM Part I

Updated 11 October 2026 · Fact-checked

The balance of payments records a country's transactions with the rest of the world: the current account, the capital account and the financial account sum to zero in principle. An exchange rate regime sets how the currency price is determined, fixed or floating. Settlement risk is the danger that one side of an FX trade pays and the other does not.

Understand Balance of Payments and Exchange Rate Regimes

The balance of payments (BoP) is a double-entry record of all economic transactions between residents of one country and the rest of the world over a period. Every transaction has two sides, so the total of all accounts is zero in principle. In practice, a small errors and omissions item balances the statistical gap.

There are three main parts. The current account covers trade in goods and services, primary income (such as interest and dividends) and secondary income (such as remittances and transfers). The capital account is small and covers capital transfers and non-produced, non-financial assets. The financial account covers direct investment, portfolio investment, other investment and reserve assets. A current account deficit must be matched by a net inflow in the financial account, meaning the country borrows from or sells assets to foreigners. Sign conventions differ by source, so read the question carefully.

An exchange rate regime is the rule a country uses to manage its currency. In a fixed (pegged) regime, the central bank commits to a target rate or band and must buy or sell foreign reserves to defend it. In a floating regime, the market sets the rate through supply and demand. Between them sit managed floats, crawling pegs and currency boards. A peg gives price stability and certainty, but the country gives up independent monetary policy if capital moves freely. This is the trilemma: you cannot have a fixed rate, free capital flows and independent monetary policy all at once.

Central bank intervention means buying or selling currency to influence its value. If the bank does not offset the effect on money supply, the intervention is unsterilized, and it changes the domestic money supply. Selling foreign currency reserves and buying domestic currency supports the domestic currency and reduces the domestic money supply. Buying foreign currency with domestic currency weakens the domestic currency and increases the domestic money supply. If the bank offsets the effect through open market operations, the intervention is sterilized, and the money supply is unchanged. Reserves are finite, so a defended peg can break under speculative attack.

FX settlement risk arises because the two legs of a trade settle in different countries and time zones. The Herstatt risk name comes from the 1974 failure of Bankhaus Herstatt. German regulators closed Bankhaus Herstatt on 26 June 1974, after it had received Deutsche Mark payments from counterparties in Frankfurt and before it made the offsetting US dollar payments in New York. CLS Bank reduces this with payment-versus-payment (PvP): each leg is paid only if the other leg is paid, so principal is not exposed.

Key formulas to remember

Balance of payments identity: Current account + Capital account + Financial account + Errors and omissions = 0; Reserve changes sit inside the financial account. This sum-to-zero form uses the older convention: credits are positive, debits are negative, and financial inflows are positive. So a current account deficit implies a net financial account inflow. Under the IMF BPM6 convention the financial account is net acquisition of financial assets minus net incurrence of liabilities. The identity then reads: current account + capital account (+ errors and omissions) = financial account net lending (+) or net borrowing (−). A current account deficit therefore shows as a negative financial account balance. Check which convention a question uses.
Current account components: Current account = Trade balance (goods and services) + Net primary income + Net secondary income; Trade balance = Exports − Imports.
Saving-investment link: Current account balance = National saving − Domestic investment; A deficit means the country invests more than it saves.
Trilemma: Choose only two of: fixed exchange rate, free capital flows, independent monetary policy; Explains why pegs force policy to follow the anchor country.
Percentage change in a quoted rate: % change = (S1 − S0) ÷ S0 × 100%; This gives the percentage change in the quoted rate, which is the price of the base currency. For a direct quote (domestic per foreign), a rise means the foreign currency appreciated and the domestic currency depreciated. For an indirect quote (foreign per domestic), a rise means the domestic currency appreciated.

How to solve Balance of Payments and Exchange Rate Regimes questions

Use the same routine for any BoP, regime or settlement question.

1Identify what is asked: an account balance, a regime feature, an intervention effect or a settlement risk.
2For BoP numbers, sort each item into current, capital or financial account before adding.
3Apply the identity: all accounts sum to zero, so the missing item is minus the sum of the others.
4For regimes, ask who sets the rate and whether the central bank must hold reserves or follow another country's policy.
5For intervention, decide the direction (buy or sell domestic currency) and whether it is sterilized.
6For settlement risk, check whether the two legs pay separately (exposed) or through PvP (protected).
7Check signs and the quote convention, then pick the option that matches exactly.

Quickest way: Sort, sum, then eliminate

When to use it: Use when a numerical BoP question or a conceptual regime question has four close options.

Write the three accounts as headings and drop each number under one.
Add what you have and flip the sign for the missing account.
For concept questions, eliminate options that break the trilemma or ignore reserves.
Choose PvP or CLS whenever the question asks how to remove principal settlement risk.

Common mistakes in Balance of Payments and Exchange Rate Regimes

Treating a current account deficit as money lost or as a budget deficit.
Everyday language mixes trade, government and BoP deficits.
Fix: A current account deficit means net borrowing from abroad, matched by a financial account inflow.
Forgetting that reserve changes sit in the financial account.
Students think reserves are a separate account.
Fix: Include reserve asset changes in the financial account when summing to zero.
Confusing the capital account with the financial account.
Both names suggest capital flows.
Fix: Investment flows (direct, portfolio, other) are financial account. Capital account is only small transfers and non-produced assets.
Saying a fixed regime allows independent monetary policy with free capital flows.
Ignoring the trilemma.
Fix: Under free capital flows, a peg forces domestic rates to track the anchor currency.
Describing Herstatt risk as credit risk on a loan or as market risk.
The name sounds like a default event.
Fix: It is principal settlement risk from non-simultaneous payment of the two legs. PvP via CLS removes it.

Worked examples

Example 1

A country reports: goods and services trade balance −USD 40 billion, net primary income +USD 6 billion, net secondary income +USD 4 billion, capital account +USD 1 billion, errors and omissions 0. Assuming the accounts sum to zero, what is the financial account balance (including reserves)?

Show the solution

Current account = −40 + 6 + 4 = −USD 30 billion.
Sum of known items = −30 + 1 + 0 = −USD 29 billion.
Financial account = −(−29) = +USD 29 billion.

Answer: The financial account balance is +USD 29 billion, a net inflow that funds the current account deficit.

Example 2

Bank A pays EUR 100 million to Bank B in Frankfurt in the morning. The payment is final and irrevocable. Bank B is due to pay USD to Bank A in New York later the same day, but Bank B fails in between. Which risk has Bank A suffered, and which mechanism would have prevented it?

Show the solution

The two legs settle in different time zones and are paid separately.
Bank A's EUR payment was final and irrevocable, so it cannot be recalled when Bank B fails.
Bank A paid its leg and did not receive the USD, so it is left without its USD and has lost principal.
This is Herstatt (principal settlement) risk.
Payment-versus-payment through CLS pays each leg only if both can be paid.

Answer: Bank A faced Herstatt (principal settlement) risk, because its irrevocable EUR payment left it without its USD. PvP settlement through CLS Bank would have prevented it.

Exam tips

Know the three BoP accounts and their contents. Questions often test which account an item falls under.
Expect a trilemma question; memorize the three corners and what each regime gives up.
For settlement risk, link Herstatt to non-simultaneous legs and CLS to PvP.
In intervention questions, separate direction (buy or sell) from sterilization (offsetting money supply).
Read the quote convention before computing any percentage change.

Practice questions from Foreign Exchange Markets

Balance of Payments and Exchange Rate Regimes in other exams

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

Balance of Payments and Exchange Rate Regimes: frequently asked questions

What is the difference between the current account and the capital account?

The current account records trade in goods and services, income and transfers. The capital account is much smaller and records capital transfers and non-produced, non-financial assets. Investment flows are in the financial account.

What is the main difference between fixed and floating exchange rate regimes?

In a fixed regime the central bank defends a target rate using reserves and gives up independent monetary policy if capital flows freely. In a floating regime the market sets the rate and the central bank keeps policy freedom, but the rate is more volatile.

What is Herstatt risk and how does CLS Bank reduce it?

Herstatt risk is the risk that one party delivers its currency while the counterparty fails before delivering the other. CLS Bank uses payment-versus-payment, so each leg settles only if both legs can settle.

What is sterilized intervention?

It is a central bank currency trade whose effect on the domestic money supply is offset through open market operations. The bank buys or sells currency but keeps the money supply unchanged.