Economic for me # 3

  The Time Value of Money

Present Value (PV)	Means How much you got now.
Future Value  (FV)	How much what you got now grows to when compounded at a given rate

I give you 100 dollars. You take it to the bank. They will give you 10% interest per year for 2 year.

• The Present Value = $ 100
• Future Value = $121.

FV= PV (1 + i )N

• FV = Future Value
• PV = Present Value
• i = the interest rate per period
• n= the number of compounding periods (monthly, quaterly, yearly even daily..)

Determine Future Value Compounded Annually
What is the future value of $34 in 5 years if the interest rate is 5%? (i=.05)

• FV= PV ( 1 + i ) ^N
• FV= $ 34 ( 1+ .05 ) ⁵
• FV= $ 34 (1.2762815)
• FV= $43.39.

Determine Future Value Compounded Monthly
What is the future value of $34 in 5 years if the interest rate is 5%? (i equals .05 divided by 12, because there are 12 months per year. So 0.05/12=.004166, so i=.004166)

• FV= PV ( 1 + i ) ^N
• FV= $ 34 ( 1+ .004166 ) ⁶⁰
• FV= $ 34 (1.283307)
• FV= $43.63.

Determine Present Value Compounded Annually
You can go backwards too. I will give you $1000 in 5 years. How much money should you give me now to make it fair to me. You think a good interest rate would be 6% ( You just made that number up). (i=.06)

• FV= PV ( 1 + i ) ^N
• $1000 = PV ( 1 + .06) ⁵
• $1000 = PV (1.338)
• $1000 / 1.338 = PV
• $ 747.38 = PV

O.K. so you give me $ 747.38 today and in 5 years I'll give you $1000. Sound fair?? You will get 6% interest on your money.

Determine Present Value Compounded Monthly
Here's that last one again, but with monthly compounding instead of annual compouding. (i equals .06 divided by 12, because there are 12 months per year so 0.06/12=.005 so i=.005)

• FV= PV ( 1 + i ) ^N
• $1000 = PV ( 1 + .005) ⁶⁰
• $1000 = PV (1.348)
• $1000 / 1.348= PV
• $741.37 = PV
• ANUITIES

An Annuity is a bunch of structured payments or equal payments made regularly, like every week or every month.

You win the lottery. The lottery guy comes to your house and says you have to choose between getting $ 1,000,000 now in one lump sum, or getting structured payments of $ 50,000 a year for the next 22 years. Which do you take?? Or, similarly, let's say you were injured on the job or whatever and were awarded an annuity of structured payments of $50,000 a year for the next 22 years. Perhaps you want to sell your annuity (the payments) to someone and get a lump sum of cash today. Is it worth $1,000,000?

First you have to choose an interest rate. Money is generally worth less in the future, right? So that $50,000 payment you get in 22 years is not going to be worth as much as it is today? You know, stuff will be more expensive then, right? So guess an interest rate, in this case, the rate of inflation for the next 22 years. Lets say 4%. Now, you have to figure out what is the present value of the $50,000 times 22 years discounted by 4% and then compare it with the million bucks. There are basically 2 ways to do this.

Use a financial calculator.

Use an annuity table.

Use a financial calculator - The PV of an Annuity.

Enter n (the number of compounding periods - in this case the number of years). Press 22 and then push the N button.

Enter i (the interest rate per period - in this case the number of years). Press 4 and then push the i button.

1. Enter FV (the future value). It is zero. You want to know the Present Value, not the future value, right? Push 0 and then push the FV button.
2. Enter PMT (the payment). You are not making a payment, you are getting one. So you have to show a negative number. Press 50000, then the CHS (change sign button), then push the PMT button.
3. Push the PV (present value) button.
4. Answer = $722,555. This means 22 annual structured payments of 50,000 each is worth only $722,555 of today's dollars. So you should take the million bucks from the lottery guy in one lump sum.

Use an annuity table - The PV of an Annuity.

Somewhere in your book, I bet there is a table that looks something like this:

	1%	2%	3%	4%
1	00.9901	00.9804	00.9703	00.9615
2	01.9704	01.9416	01.9135	01.8861
3	02.9410	02.8839	02.8286	02.7751
4	03.9020	03.8077	03.7171	03.6299
5	04.8534	04.7135	04.5797	04.4518
6	05.7955	05.6014	05.4172	05.2421
7	06.7282	06.4720	06.2302	06.0021
8	07.6517	07.3255	07.0197	06.7327
9	08.5660	08.1622	07.7861	07.4353
10	09.4713	08.9826	08.5302	08.1109
11	10.3676	09.7868	09.2526	08.7605
12	11.2551	10.5753	09.9450	09.3851
13	12.1337	11.3484	10.6350	09.9856
14	13.0037	12.1062	11.2961	10.5631
15	13.8651	12.8493	11.9379	11.1184
16	14.7179	13.5777	12.5611	11.6523
17	15.5623	14.2919	13.1661	12.1657
18	16.3983	14.9920	13.7535	12.6593
19	17.2260	15.6785	14.3238	13.1339
20	18.0456	16.3541	14.8775	13.5903
21	18.8570	17.0112	15.4150	14.0292
22	19.6604	17.6580	15.9369	14.4511

1. Find this table.
2. On the left, find the number of compounding periods (in this case years) - 22
3. On the top, find the interest rate - 4%
4. Find below where they meet. It says 14.4511
5. Multiply 14.4511 times the Payment - $50,000
6. Answer = $722,555. This means 22 annual structured payments of 50,000 each is worth only $722,555 of today's dollars. So you should take the million bucks from the lottery guy in one lump sum.

     Perpetuities

Perpetuities -

are equal payments made regularly, like every month or every year, that go on forever.

You are rich. (Yes, but are you really happy?) You want to start the YOUR NAME HERE Scholarship at your university. Every year, some student will receive a $1000 scholarship. You're paying for it. Even after you, your kids and your grandkids are dead, you are still paying for it. Forever.

The question is....How much money will it cost you. In today's dollars. What is the present value of this perpetuity. (Hint: starting now and going on forever and ever, you assume the interest rate at your bank is going to be 3%).

PV (of a perpetuity) = payment / interest rate

Every year the interest you earn is used to pay for the scholarship. The principal in your bank account doesn't really change year to year.

• PV (of a perpetuity) = payment / interest rate
• PV = $ 1000 / .03
• PV = $ 33,333

So, you put $ 33,333 into the bank. Each year the money earns $1000 interest. That interest becomes the scholarship.

   Kinds of Interest Rates

Let's say I give you a credit card and the interest rate on the card is 3% per month. What is the annual rate that you are actually charged?? 36%?? Well, no. It's actually 42.57%.

Nominal Rate	Nominal means "in name only". This is sometimes called the quoted rate.
Periodic Rate	The amount of interest you are charged each period, like every month.
Effective Annual Rate	The rate that you actually get charged on an annual basis. Remember you are paying interest on interest.

In the example

• The Nominal Rate is 36%.
• The Periodic Rate is 3% (you are charged 3% interest on your balance every month)
• The Effective Annual Rate is 42.57%

Nominal Rate = Periodic Rate X Number of Compounding Periods

Effective Annual Rate = (1+ i / m)m -1

• m = the number of compounding periods
• i = the nominal interest rate

O.K., so let's try the example again.

• Effective Annual Rate = (1+ i / m)^m -1
• Effective Annual Rate = ( 1 + .36 / 12 )¹² -1
• Effective Annual Rate = (1.03)¹² - 1
• Effective Annual Rate = (1.4257) -1
• Effective Annual Rate = .4257
• Effective Annual Rate = 42.57 %

         Future Value of an Uneven Cashflow

Cash Flow

Cash Flow is money you get a little at a time.

Lets say, for example that for the next 4 years you will get the following cash flow.

Cash Flow
in 1 year	$ 320
in 2 years	$ 400
in 3 years	$ 650
in 4 years	$ 300

If you assume that the interest rate is 6.5% (which means that after you get the money, it will be invested and you will get 6.5% interest from it), compounded monthly, how much money will you have in 4 years? In other words, what will the future value of this cash flow be?

Compounding Formula

FV=PV ( 1 + i / m)mn

• FV = Future Value
• PV = Present Value
• i = Interest rate (annual)
• m = number of compounding periods per year
• n = number of years

So you have to figure out the future value of each payment and then add them together.

First Payment

• FV = PV ( 1 + i / m)^mn
• FV = $320 (1 + .065 / 12 )^{12 X 3} (three years)
• FV = $320 (1.0054167)³⁶
• FV = $320 (1.2146716)
• FV = $388.69

Second Payment

• FV = PV ( 1 + i / m)^mn
• FV = $400 (1 + .065 / 12 )^{12 X 2} (two years)
• FV = $400 (1.0054167)²⁴
• FV = $400 (1.1384289)
• FV = $455.37

Third Payment

• FV = PV ( 1 + i / m)^mn
• FV = $650 (1 + .065 / 12 )^{12 X 1} (one year)
• FV = $650 (1.0054167)¹²
• FV = $650 (1.0669719)
• FV = $693.53

Fourth Payment - ( The payment is not compounded. There no time to earn interest)

• FV = PV ( 1 + i / m)^mn
• FV = $300 (1 + .065 / 12 )^{12 X 0}(0 years.)
• FV = $300 (1.0054167)⁰
• FV = $300 (1) (remember anything to the power of zero is 1)
• FV = $300

Finally, add up all the numbers

$ 388.69
$ 455.37
$ 693.53
$ 300.00
----------
$1,837.59

So after 4 years, you will have $1,837.59. That is the future value of your uneven cash flow.

• Probability Distribution

Probability Distribution- The weather this weekend

Outcome	Probability
Sunny	80 %
Rain	10 %
Snow	9.99995 %
Volcanic Ash	0.00005 %

The total must equal 100%

Probability Distribution - In Business

Economic Outcome	Probability	Return on Investment
Great	20%	25%
Good	40%	15%
So-So	30%	5%
Really Bad	10%	0%

• Economic Outcome = What might happen next year to the country's overall economy.
• Probability = Estimate of the likelihood that the economy will be in each outcome.
• Return on Investment = Estimate of your profit in each economic outcome.

Taking a Weighted Average - Expected Rate of Return (ERR)

What is the most likely return on your investments next year? Just multiply it out and add.

Probability	Times	Outcome	Equals	Result
20%	X	25%	=	5%
40%	X	15%	=	6%
30%	X	5%	=	1.5%
10%	X	0%	=	0%
			Total	12.5%

So after taking a weighted average the Expected Rate of Return (ERR) is 12.5%

• Standard Deviation

We can measure risk by using standard deviation. Higher standard deviation means higher risk.

Here is the example from the probability distribution page

Probability Distribution - In Business

Economic Outcome	Probability	Return on Investment
Great	20%	25%
Good	40%	15%
So-So	30%	5%
Really Bad	10%	0%

(Sorry, I don't know how to write sigma and the square root sign in html, so I can't show you the formula for Standard Deviation, but you can still plug in your numbers to the chart below)

Economic Outcome	Return on Investment	minus	ERR - the Expected Rate of Return	equals	answer	squared	times	Probability of the Economic Outcome	equals	Answer
Great	25%	-	12.5%	=	12.5	156.25	X	20%	=	31.25
Good	15%	-	12.5%	=	2.5	6.25	X	40%	=	2.5
So-So	5%	-	12.5%	=	7.5	56.25	X	30%	=	16.875
Really Bad	0%	-	12.5%	=	12.5	156.25	X	10%	=	15.625
								Total	=	66.25

• So the total is 66.25. This is called the Variance.
• The square root of 66.25 = 8.139
• So the Standard Deviation is 8.139

 CAPM - The Capital Asset Pricing Model

"Cap-M" looks at risk and rates of return and compares them to the overall stock market. If you use CAPM you have to assume that most investors want to avoid risk, (risk averse), and those who do take risks, expect to be rewarded. It also assumes that investors are "price takers" who can't influence the price of assets or markets. With CAPM you assume that there are no transactional costs or taxation and assets and securities are divisible into small little packets. Had enough with the assumptions yet? One more. CAPM assumes that investors are not limited in their borrowing and lending under the risk free rate of interest. By now you likely have a healthy feeling of skepticism. We'll deal with that below, but first, let's work the CAPM formula.

Beta - Now, you gotta know about Beta.  Beta is the overall risk in investing in a large market, like the New York Stock Exchange. Beta, by definition equals 1.0000. 1 exactly. Each company also has a beta. You can find a company's beta at the Yahoo!! Stock quote page. A company's beta is that company's risk compared to the risk of the overall market. If the company has a beta of 3.0, then it is said to be 3 times more risky than the overall market.

Ks = Krf + B ( Km - Krf)

• Ks = The Required Rate of Return, (or just the rate of return).
• Krf = The Risk Free Rate (the rate of return on a "risk free investment", like U.S. Government Treasury Bonds - Read our Disclaimer)
• B = Beta (see above)
• Km = The expected return on the overall stock market. (You have to guess what rate of return you think the overall stock market will produce.)

As an example, let's assume that the risk free rate is 5%, and the overall stock market will produce a rate of return of 12.5% next year. You see that XYZ company (Read our Disclaimer) has a beta of 1.7.

What rate of return should you get from this company in order to be rewarded for the risk you are taking? Remember investing in XYZ company (beta =1.7) is more risky than investing in the overall stock market (beta = 1.0). So you want to get more than 12.5%, right?

• Ks = Krf + B ( Km - Krf)
• Ks = 5% + 1.7 ( 12.5% - 5%)
• Ks = 5% + 1.7 ( 7.5%)
• Ks = 5% + 12.75%
• Ks = 17.75%

So, if you invest in XYZ Company, you should get at least 17.75% return from your investment. If you don't think that XYZ Company will produce those kinds of returns for you, then you would probably consider investing in a different stock

Who introduced the CAPM - Capital Asset Pricing Model?

Harry Markowitz worked on diversification and modern portfolio theory. Jack Treynor, John Lintner, Jan Mossin and William Sharpe all contributed to the theory of CAPM. William Sharpe, Harry Markowitz and Merton Miller jointly got a Nobel Prize in Economics for contributing to financial economics. See, if you study hard and think up new stuff maybe you can get a Nobel Prize too.

Ah, but CAPM has some flaws. (don't we all)

• If you go to a casino, you basically pay for risk. It's possible that the folks on Wall Street sometimes have the same mindset as well. Now remember that CAPM assumes that given "X%" expected return investors will prefer lower risk (in other words lower variance) to higher risk. And the opposite would be true as well - given a certain level of risk investors would prefer higher returns to lower ones. OK, but maybe the Wall Street people get a kick out of "gambling" their investment. Not saying it's been proven to be the case, just saying it could be. CAPM doesn't allow for investors who will accept lower returns for higher risk.
• CAPM assumes that asset returns are jointly normally distributed random variables. But often returns are not normally distributed. So large swings, swings as big as 3 to 6 standard deviations from the mean, occur in the market more frequently than you would expect in a normal distribution.

·         CAPM assumes that the variance of returns adequately measures risk. This might be true if returns were distributed normally. However other risk measurements are probably better for showing investors' preferences. Coherent risk measures comes to mind.

• With CAPM you assume that all investors have equal access to information and they all agree about the risk and expected return of the assets. This idea, by the way is called "homogeneous expectations assumption". Be ready for your professor to ask, "What's the Homogeneous Expectations Assumption and do you believe it's valid". Good luck with that one.
• CAPM can't quite explain the variation in stock returns. Back in 1969, Myron Scholes, Michael Jensen and Fisher Black presented a paper suggesting that low beta stocks may offer higher returns than the model would predict.
• CAPM kind of skips over taxes and transaction costs. Some of the more complex versions of CAPM try to take this into consideration.
• CAPM assumes that all assets can be divided infinitely and that those small assets can be held and transacted.
• Roll's Critique: Back in 1977, Richard Roll offered the idea that using stock indexes as a proxy for the true market portfolio can lead to CAPM being invalid. The true market portfolio should include stuff like real estate, human capital, works of art and so on, basically anything that anyone holds as an investment. However, the markets for those assets are often non-transparent and unobservable. So often financial people will use a stock index instead. Does it kind of seem like they are fudging a little bit. You might argue they are.
• CAPM assumes that individual investors have no preference for markets or assets other than their risk-return profile. But is that really the case? Say a guy loves drinking Coke. Only Coke. He's collects old Coke bottles and stuff. OK, now, is that guy going to buy stock in Pepsi based only on its risk-return profile, or is he going to buy stock in Coke so he can brag to everyone about how many shares he has?

The Security Market Line

The formula for CAPM is Ks = Krf + B ( Km - Krf).

Let's assume that the risk free rate is 5%, and the overall stock market will produce a rate of return of 12.5% next year. You see that XYZ company (Read our disclaimer) has a beta of 1.7

I f you make a graph of this situation, it would look like this:

• On the horizontal axis are the betas of all companies in the market
• On the vertical axis are the required rates of return, as a percentage

The red line is the Security Market Line.

How did we get it? We plugged in a few sample betas into the equation
Ks = Krf + B ( Km - Krf).

Security	Beta (measures risk)	Rate of Return
'Risk Free'	0.0	5.00%
Overall Stock Market	1.0	12.50%
XYZ Company	1.7	17.75%

       Bond Valuation

Bond	When a company (or government) borrows money from the public or banks (bondholders) and agrees to pay it back later
Par Value	The amount of money that the company borrows. Usually it is $1,000.
Coupon Payments	This is like interest. The company makes regular payments to the bondholders, like every 6 months or every year.
Indenture	The legal stuff. A written agreement between the company and the bond holder. They talk about how much the coupon payments will be, and when the money (par value) will be paid back to the bondholder.
Maturity Date	Date when the company pays the par value back to the bondholder.
Market Interest Rate	This changes everyday.

The thing about bonds is that the interest rate (coupon payments) is fixed. It doesn't change. And bonds last a long time. Like 10 years or whatever. So in the meantime, the market interest rate (the interest rates in general) go up and down. OK, well, if the coupon payments are for 10% and then the market interest rates fall from 10% to 8%, then that bond at 10% is valuable, right. It is paying 10% while the overall interest rate is only 8%. Exactly how much is it worth? You mean 'what is the present value of a bond?'

The Present Value of a Bond

=

The Present Value of the Coupon Payments (an annuity)

+

The Present Value of the Par Value (time value of money)

Example

• Par Value = $ 1,000
• Maturity Date is in 5 years
• Annual Coupon Payments of $100, which is 10%
• Market Interest rate of 8%

The Present Value of the Coupon Payments (an annuity) = $399.27

The Present Value of the Par Value (time value of money) =$680.58

The Present Value of a Bond = $ 399.27 + $ 680.58 = $1,079.86

Stock Valuation 

Preferred Stock	Preferred stock is somewhat like a bond. They pay the same equal dividends forever.
Common Stock	Common stock represents ownership in the company. Sometimes there are dividends, sometimes not.

What is the value of Preferred Stock?

This is easy. Preferred stock is basically a perpetuity.

What is the value of Common Stock?

This is not easy. This is a mess. Think about it. What is the value of a share of stock in a specific company? In one sense it is the price the stock trades at. Both the buyer and seller agree to exchange the stock at that price.

We assume that they are both rational people and both know something about the company and its future plans and profit potential. So, yes, that is one method: check the price of the stock in the paper or on the internet. But that's pretty darn easy. It's not really finance. It's more like reading. And I don't know if you realize this or not, but they don't give Nobel Prizes for reading. So there are other ways of doing stock valuation too.

The Gordon Growth Formula, also known as The Constant Growth Formula assumes that a company grows at a constant rate forever. This, by the way, is impossible. I mean, it can't grow forever. You know, if a company doubles in size every 5 years, pretty soon every single person in the world is their customer and then they can't grow at that rate anymore. (because the world population isn't doubling ever 5 years).

BUT, if we go ahead and assume that a company has a constant growth rate, we can use the following formula to get its value.

Constant Growth Formula

Po = D 1 / ( Ks - G )

• Po = Price
• D1 = The next dividend. D1 = D0 (1 + G)
• Ks = Rate of Return
• G = Growth Rate

What is all this D1 and D0 stuff ?

• D1 is the next dividend
• D0 is the last dividend

Well we are assuming that the company has constant growth, right. So we take the last divided, multiply it by the growth rate and we can get the next dividend.

Example

• Last years dividend = $ 1.00
• Growth Rate = 5%
• Rate of Return = 10%

First figure out D1.

• D1 = D0 (1 + G)
• D1 = $1.00 ( 1 + .05)
• D1 = $1.00 (1.05)
• D1 = $1.05

Next us the formula.

• Po = D 1 / ( Ks - G )
• Po = $1.05 / (10% - 5%)
• Po = $1.05 / 5%
• Po = $21.00

So, if we want to get a 10% rate of return on our money, and we assume that the company will grow forever at 5% per year, then we would be willing to pay $21.00 for this stock. That is the theory anyways. And again, here is our disclaimer. 

Cost of Capital

How can a company raise money to build, for example, a new factory?

What are the Capital Components?

• Common Stock
• Preferred Stock
• Bonds (debt)
• Retained Earnings - (profit the company makes, but does not give to the shareholders in the form of dividends)

Each of these components has a cost. We can determine the cost of each capital component.

Cost of Retained Earnings

This is kind of weird to think about. It takes some time to understand so take it slowly. After a company makes money (earnings), who owns that money? The shareholders, right? But when you retain earnings you are not giving the money to the shareholders. You are keeping it. In a way, you are investing it for them in your company. Well those shareholders want some return on that money you are keeping.. How much return do they expect? They want the same amount as if they had gotten the retained earning in the form of dividends, and bought more stock in your company with them. THAT is the cost of retained earnings. You as a financial genius, have to ensure that if you are retaining earning, that the shareholders will get at least as good a return on the money as if they had re-invested the money back into the company.

If you don't understand this, re-read it and re-think it until you do get it. There is really no "cost" in the cost of retained earnings. I mean, no money is changing hands. You aren't paying anyone anything. But you are keeping the shareholders money. You can't say it is "free" money. Frankly if you did, it would screw up your capital budgeting. So when you are doing your capital budgeting, to ensure that the shareholders are getting a decent rate of return, you "guess" a cost of retained earnings. How?? One way is CAPM. Another way is the bond yield plus risk premium approach, in which you take the interest rate on the company's own long term debt and then add between 5% and 7%. Again, you are kind of guessing here. A third way is the discounted cash flow method, in which you divide the dividend by the price of stock and add the growth rate. Again, a lot of guessing.

Cost of Issuing Common Stock

Flotation Cost of Common Stock

=

Costs of issuing the actual stock (ink, printing, paper, computers, etc.)

+

The cost of retained earnings.

Cost of Preferred Stock

Cost of Preferred Stock	=	What you give.	divided by	What you get.
Cost of Preferred Stock	=	Dividend	divided by	Price - Underwriting Costs

Cost of Bonds (debt)

Cost of Debt

=

Coupon rate on the bonds

minus

The Tax Savings

Interest on bonds is tax deductible. So we can reduce our taxable income by the amount of money we pay to the bondholders.

WACC - The Weighted Average Cost of Capital.

Every company has a capital structure - a general understanding of what percentage of debt comes from retained earnings, common stocks, preferred stocks, and bonds. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. This is the weighted average cost of capital.

Capital Component	Cost	Times	% of capital structure	Total
Retained Earnings	10%	X	25%	2.50%
Common Stocks	11%	X	10%	1.10%
Preferred Stocks	9%	X	15%	1.35%
Bonds	6%	X	50%	3.00%
TOTAL				7.95%

So the WACC of this company is 7.95%.

The Balance Sheet
The balance sheet is like a flash, a snapshot of the company's financial situation at a given moment. You must (absolutely must) memorize this equation.

Assets = Liabilities + Equity

Assets

something that is valuable that the company owns

Assets can include...

• Cash you know. Cash is money.
• Accounts Receivable is the money that the customers owe the company.
• Inventory is stuff a company buys and then resells to make a profit.
• Notes Receivable is money owed to a company when the company makes a loan. Why is the company making loans? Are they a bank? No, but loans are sometimes made to people like customers or employees. For example if a customer couldn't pay for something (i.e. didn't pay an invoice on time) the money could go from being an account receivable to a note receivable. Another example would be if the company loaned money to an employee for a down payment on a house or car or something.
• Fixed Assets are when cash is used to buy stuff that you expect will still be useful one year from now, like land machinery and equipment, furniture buildings.
• Intangibles are when you use cash to buy stuff that may or may not eventually become profitable. Things like patents, market research, research and development and organizational expenses. Intangibles are usually amortized over a period of time because they have a long life.

Liabilities

money the company owes

Liabilities include...

• Current Liabilities - money that has to be repaid within 1 year
• Notes Payable are loans the company has to pay back within 1 year.
• Accounts Payable is money the company owes its suppliers and vendors for raw materials, inventory, that kind of stuff.
• Current Portion of Long-term Debt would be like if you had a 10-year loan, then money you had to pay during the next 1 year as part of that 10-year loan.
• Accrued Expenses - is basically a labor related category. Wages, salary, payroll taxes, employee benefits like pension funds go here.
• Non-Current Liabilities - money that doesn't have to be paid within 1 year.
• Non-current Portion of Long Term Debt - remember that 10-year loan we talked about before? Well, the other 9 years of the 10-year loan would go here.
• Subordinated Officer Loans are kind of tricky. Say an officer of the company or an owner loans money to the company. OK, now say the company needs more money so it goes to a bank to get another loan. Well, the bank loan would take a higher priority than the Officer Loan, so the Officer Loan is said to be subordinated. It means they are kind of put on standby. Because the owner/officer would be willing to wait until later to collect the loan, it is non-current, and would go here. Generally, these loans are considered to be equity, rather than debt, when they are subordinated.
• Contingent Liabilities - are possible liabilities, but aren't usually listed in the balance sheet itself, and are listed in the footnotes. The company hopes that these liabilities never actually develop. A good example is ongoing lawsuits. If the company has been sued, or reasonably expects that it will be sued, but doesn't know how much it will have to pay to settle the suit (if anything) it will be mentioned here. Another example is if the company acted as a guarantor on a loan for a third party, there is the possibility that the third party will default on the loan, and then the company will have to pay, so that would also go here.

Equity

Equity is what is left over, the value the owners have. It's sometimes called Net Worth or Owner's Equity.

Capital Budgeting

Payback, Discounted Payback, NPV, Profitability Index, IRR and MIRR are all capital budgeting decision methods.

Cash Flow- We are going to assume that the project we are considering approving has the following cash flow. Right now, in year zero we will spend 15,000 dollars on the project. Then for 5 years we will get money back as shown below.

Year	Cash flow
0	-15,000
1	+7,000
2	+6,000
3	+3,000
4	+2,000
5	+1,000

Payback - When exactly do we get our money back, when does our project break even. Figuring this is easy. Take your calculator.

Year	Cash flow	Running Total
0	-15,000	-15,000
1	+7,000	-8,000	(so after the 1st year, the project has not yet broken even)
2	+6,000	-2,000	(so after the 2nd year, the project has not yet broken even)
3	+3,000	+1,000	(so the project breaks even sometime in the 3rd year)

But when, exactly? Well, at the beginning of the year we had still had a -2,000 balance, right? So do this.

Negative Balance / Cash flow from the Break Even Year	=	When in the final year we break even
-2,000 / 3,000	=	.666

So we broke even 2/3 of the way through the 3rd year. So the total time required to payback the money we borrowed was 2.66 years.

Discounted Payback - is almost the same as payback, but before you figure it, you first discount your cash flows. You reduce the future payments by your cost of capital. Why? Because it is money you will get in the future, and will be less valuable than money today. (See Time Value of Money if you don't understand). For this example, let's say the cost of capital is 10%.

Year	Cash flow	Discounted Cash flow	Running Total
0	-15,000	-15,000	-15,000
1	7,000	6,363	-8,637
2	6,000	4,959	-3,678
3	3,000	2,254	-1,424
4	2,000	1,366	-58
5	1,000	621	563

So we break even sometime in the 5th year. When?

Negative Balance / Cash flow from the Break Even Year	=	When in the final year we break even
-58 / 621	=	.093

So using the Discounted Payback Method we break even after 4.093 years.

Net Present Value (NPV) - Once you understand discounted payback, NPV is so easy! NPV is the final running total number. That's it. In the example above the NPV is 563. That's all. You're done, baby. Basically NPV and Discounted Payback are the same idea, with slightly different answers. Discounted Payback is a period of time, and NPV is the final dollar amount you get by adding all the discounted cash flows together. If the NPV is positive, then approve the project. It shows that you are making more money on the investment than you are spending on your cost of capital. If NPV is negative, then do not approve the project because you are paying more in interest on the borrowed money than you are making from the project.

Profitability Index

Profitability Index	equals	NPV	divided by	Total Investment	plus	1
PI	=	563	/	15,000	+	1

So in our example, the PI = 1.0375. For every dollar borrowed and invested we get back $1.0375, or one dollar and 3 and one third cents. This profit is above and beyond our cost of capital.

Internal Rate of Return - IRR is the amount of profit you get by investing in a certain project. It is a percentage. An IRR of 10% means you make 10% profit per year on the money invested in the project. To determine the IRR, you need your good buddy, the financial calculator.

Year	Cash flow
0	-15,000
1	+7,000
2	+6,000
3	+3,000
4	+2,000
5	+1,000

Enter these numbers and press these buttons.

-15000	g	CFo
7000	g	CFj
6000	g	CFj
3000	g	CFj
2000	g	CFj
1000	g	CFj
f	IRR

After you enter these numbers the calculator will entertain you by blinking for a few seconds as it determines the IRR, in this case 12.02%. It's fun, isn't it!

Ah, yes, but there are problems.

• Sometimes it gets confusing putting all the numbers in, especially if you have alternate between a lot of negative and positive numbers.
• IRR assumes that the all cash flows from the project are invested back into the project. Sometimes, that simply isn't possible. Let's say you have a sailboat that you give rides on, and you charge people money for it. Well you have a large initial expense (the cost of the boat) but after that, you have almost no expenses, so there is no way to re-invest the money back into the project. Fortunately for you, there is the MIRR.

Modified Internal Rate of Return - MIRR - Is basically the same as the IRR, except it assumes that the revenue (cash flows) from the project are reinvested back into the company, and are compounded by the company's cost of capital, but are not directly invested back into the project from which they came.

WHAT?

OK, MIRR assumes that the revenue is not invested back into the same project, but is put back into the general "money fund" for the company, where it earns interest. We don't know exactly how much interest it will earn, so we use the company's cost of capital as a good guess.

Why use the Cost of Capital?

Because we know the company wouldn't do a project which earned profits below the cost of capital. That would be stupid. The company would lose money. Hopefully the company would do projects which earn much more than the cost of capital, but, to play it safe, we just use the cost of capital instead. (We also use this number because sometimes the cash flows in some years might be negative, and we would need to 'borrow'. That would be done at our cost of capital.)

How to get MIRR - OK, we've got these cash flows coming in, right? The money is going to be invested back into the company, and we assume it will then get at least the company's-cost-of-capital's interest on it. So we have to figure out the

future value (not the present value) of the sum of all the cash flows. This, by the way is called the Terminal Value. Assume, again, that the company's cost of capital is 10%. Here goes...

Cash Flow	Times		=	Future Value of that years cash flow.	Note
7000	X	(1+.1) 4	=	10249	compounded for 4 years
6000	X	(1+.1) 3	=	7986	compounded for 3 years
3000	X	(1+.1) 2	=	3630	compounded for 2 years
2000	X	(1+.1) 1	=	2200	compounded for 1 years
1000	X	(1+.1)0	=	1000	not compounded at all because this is the final cash flow
TOTAL			=	25065	this is the Terminal Value

OK, now get our your financial calculator again. Do this.

-15000	g	CFo
0	g	CFj
0	g	CFj
0	g	CFj
0	g	CFj
25065	g	CFj
f	IRR

Why all those zeros? Because the calculator needs to know how many years go by. But you don't enter the money from the sum of the cash flows until the end, until the last year. Is MIRR kind of weird? Yep. You have to understand that the cash flows are received from the project, and then get used by the company, and increase because the company makes profit on them, and then, in the end, all that money gets 'credited' back to the project. Anyhow, the final MIRR is 10.81%.

Decision Time- Do we approve the project? Well, let's review.

Decision Method	Result	Approve?	Why?
Payback	2.66 years	Yes	well, cause we get our money back
Discounted Payback	4.195 years	Yes	because we get our money back, even after discounting our cost of capital.
NPV	$500	Yes	because NPV is positive (reject the project if NPV is negative)
Profitability Index	1.003	Yes	cause we make money
IRR	12.02%	Yes	because the IRR is more than the cost of capital
MIRR	10.81%	Yes	because the MIRR is more than the cost of capital

• Credit Reports in The United States

What is a Credit Report ?

A credit report is a record of your credit activities that lists credit-card accounts or loans you may have, the balances, and how regularly you make your payments. It also shows if there has been any action has been taken against you because you have not paid you bills.

The four most common pieces of information on your credit report are: 1) Identifying information like your name, any aliases, current address, previous address, social security number, date of birth, current employer, past employer, and, if you are married, the same information about your spouse. 2) Credit Information like what bank accounts you have, credit cards with stores, general credit cards, if you pay your utilities on-time, mortgages, student loans, revolving credit, installment loans. Loan information will likely include when you opened the account, your credit limit, the loan amount, who the co-signers were on the loan and your payment history. 3) Public information like any bankruptcies, tax liens, monetary and non-monetary judgments. 4) The names of whoever got copies of your credit report in the past year (for credit cards) or two (for employment purposes).

Your credit history remains on file for about seven years, usually. Personal bankruptcies will be on your credit report for ten years.

Who can look at your Credit Report?

Employers often check to see if you are reliable before offering you a job. Landlords usually want to see it to make sure you will live up to your lease. Lenders, like banks and mortgage companies check before offering you a loan. And, you can get a free copy of your credit report, if you live in the US, once a year, by calling 1-877-322-8228.

What is a Credit Score?

Creditors use a credit scoring help determine whether to give you credit, and if so, how much. Your credit score will usually be determined by; Payment History, Amounts Owed, Number of Accounts Owned, Length of Credit History, New Credit, Types of Credit Used. Creditors use a statistical formula to compare this information to the credit performance of consumers with similar profiles. A credit scoring system awards points for each factor. A total number of points a credit score helps predict how likely it is that you will repay a loan and make the payments on time in other words, how creditworthy you are.

There is a big difference between having good credit and bad credit.

As an example, say you want to buy a used car for $12,000, with a down payment of $2,000 and a loan of $10,000. And you want a 48-month loan.

If you have a good credit score of say between 720 and 850 you might get a loan at an annual percentage rate of 4.97%, and your monthly payments would be $230. You would end up paying $1,047 in interested over the course of the loan.

However, if you have a not-so-good credit score of say 500 to 589, you might get a loan at an annual percentage rate of 15.83%, and your monthly payments would be $283. You would end up paying $3,562 in interest over the course of the loan.

Tips to Improve your Score

Most importantly, pay your bills on time. Payment history is an extremely important factor. Your credit score will be hurt if you pay your bills late, have an account sent to collections, or declare bankruptcy. Scoring systems often compare the amount of debt you have with your credit limits. Your score will likely be lower if the amount you owe is near your credit limit. Although having an insufficient credit history might hurt your credit score you can probably offset that by making timely payments and having low balances. Credit scoring systems take into account whether you have applied for credit recently. Applying for too many you accounts can hurt your credit score. Finally , although it's important to establish credit accounts, having too many credit card accounts may lower your credit score. Also, credit rating scoring systems sometimes reduce credit scores when you have loans from finance companies.

Bankruptcy

The results of personal bankruptcy are far-reaching and long-lasting. Personal bankruptcy is generally considered to be the option of last resort /tactic for debt management. Your credit report will show a bankruptcy for 10 years, which can make it difficult for you to buy a home, get life insurance, obtain credit and even possibly make it difficult to get a job. However, bankruptcy is a legal procedure that allows people who can't pay their debts to have somewhat of fresh start. When people follow the bankruptcy rules they often receive discharge /payment/dismiss which is court order saying they do not have to repay some of their debts. You should consider the consequences of bankruptcy carefully.

In October 2005, the US Congress made large changes to the bankruptcy laws. Because of these changes consumers are more likely to seek bankruptcy relief under Chapter 13 than under Chapter 7. If you have a steady income Chapter 13 allows you to keep property such as a car or a mortgaged house that you otherwise might have lost. With Chapter 13 the court approves a plan for repayment that lets you use your future income to repay your debts over 3 to 5 year instead of surrendering property. Then, after you have made the payments in the plan, you would receive a discharge of your debts.

Chapter 7 bankruptcy is also known as straight bankruptcy. Chapter 7 bankruptcy involves the selling of all assets that are not exempt. Property that is exempt often includes things like cars, basic household furnishings, and tools you need for work. A trustee, a court appointed official, may sell some of your property or your property may be turned over directly to your creditors. The time period during which you can receive a discharge through Chapter 7 has changed based on the new bankruptcy laws. Now you have to wait eight years after receiving a Chapter 7 discharge before you can file again under that chapter. The waiting period for Chapter 13 is much shorter. It can be as little as two years between filings. Both Chapter 7 and Chapter 13 bankruptcies may help you get rid of unsecured debts and stop foreclosure, garnishments, debt collection activities, utility shutoffs and repossessions of property.

With both Chapter 13 and Chapter 7 bankruptcies you're allowed to keep certain assets, although this varies state by state. Things that are usually not erased in a personal bankruptcy include things like child support, fines, taxes, alimony and some student loans. Bankruptcy usually does not allow you to keep property if your creditor has a security lien or unpaid mortgage on it, unless you have an acceptable plan to repay your debts. Other recent changes in bankruptcy laws include obstacles you must overcome before filing for bankruptcy. For example, you have to get credit counseling from an organization approved by the government within six months before you file for any bankruptcy relief. You must satisfy a means test before you file Chapter 7 bankruptcy. The means test confirms that your income is below a certain amount. The amount varies by state.

Debt collectors

There are certain things debt collectors cannot do. For example, debt collectors cannot contact you at work if your employer disapproves of the phone calls. Also, debt collectors cannot lie to you, harass you, or use unfair business practices. They are also obligated to honor written requests from you instructing them to no longer contact you.

Forex - Foreign Currency Exchange

Foreign Exchange - FX


Forex or FX for short means foreign exchange. Up until a few years ago, foreign currencies were usually traded by corporations, central banks, hedge funds, large financial institutions, and very wealthy individual traders. But like many things, foreign exchange changed dramatically with the Internet. Now, individual investors are able to buy and sell currencies much more easily than before.

Often, pairs of currencies fluctuate only around 1% or less per day, so foreign exchange is often considered to be a relatively stable market. Speculators sometimes use enormous leverage to try to make money off of these small fluctuations. Leverage in foreign markets can be as high as 250 to 1. With leverage of course comes risk, and high leverage, such as 250 to 1, can be extremely risky.

Foreign currency markets are often open around the clock, 24 hours a day, during most business days. Markets are relatively liquid. Investors are often able to open and close positions within minutes, or hold those positions for months. Because the currency markets are so large, even the largest players, such as central banks, are often unable to move prices it will.

Although the Forex market provides investors with plenty of opportunity, currency traders have to understand the basics of currency trading in order to be successful.

People need foreign currency in order to conduct foreign business and trade with other countries. For example, if you're living in Japan and want to buy wine from California, you would have to change your Japanese yen to US dollars to purchase the wine. The same thing happens when you travel abroad. If you want to buy cheese from a supermarket in France you most likely won't be able to pay with US dollars.

Now imagine all of the international trade that occurs in the world and you'll see why the size of the Forex market is so large. In April of 2007, the Bank for International Settlements reported that daily turnover was over $3.2 trillion.

One thing that is unusual about the currency market is that there is no central marketplace. Transactions occur electronically over computer networks between traders all around the world in places like London, Tokyo, New York, Frankfurt, Paris, Hong Kong, Singapore and Sydney. The market is usually open around the clock, 5 1/2 days a week.

The futures market, the forwards market, and the spot market are three ways that corporations, institutions and individuals trade Forex. The underlying

/basic  real asset is the spot market. The spot market is also the largest market. The futures markets and forwards markets are based on the spot market. When people talk about the Forex market they are usually talking about the spot market. The forwards and futures markets are usually more often traded by companies in order to hedge foreign exchange risks to a specific time in the future.
The spot market is where supply and demand meet and where currencies are bought and sold. The spot market price is based on many things including economic performance, current interest rates, local and international political situations, and a belief in the future performance of one currency against another. When a currency transaction is finalized it's called a spot deal. In a spot deal, one party agrees to deliver a certain amount of a certain currency to a counterpart and receives a certain amount of another currency at a certain exchange rate. The settlement is made in cash after the position is closed. Trades in the spot market usually take two days for settlement.

Forwards markets and futures markets are different from the spot market in that they do not trade actual currencies.
They instead deal contracts. These contracts represent claims to specific currency types, specific future dates for settlement, and specific prices per unit. Contracts in the forwards market are bought and sold over-the-counter at the terms that the buyer and seller agreed to between themselves. Futures contracts are bought and sold in the futures market based on standard sizes and settlement dates. The National Futures Association regulates the futures market in the United States. Specific details in futures contracts include the number of units traded, delivery date and settlement date. The minimum price increments in futures contracts cannot be customized. The exchange provides clearance and settlement by acting as a counterpart into the trader.
Before they expire contract can be bought and sold. However, contracts are typically settled for cash when they expire. Both types of contract are binding. The futures markets and forwards markets can offer a degree of protection against currency trading risks. Large multinational companies often use the forwards and futures markets as a hedge against fluctuations in future exchange rates. Speculators also are known to take part in these markets.

Reading Quotes
Here is a currency quote, also called a currency pair: USD/JPY=95.50. The currency on the left-hand side of the slash is called the base currency. In this case the US dollar is the base currency. The currency on the right-hand side of the slash is called the quote currency or counter currency. In this case the quoted currency is the Japanese yen. The base currency is always equal to one unit so in this case one US dollar. This quote means that one US dollar can buy 95.50 Japanese yen.

The two ways to quote a currency pair are directly and indirectly. In a direct quote, the domestic currency is the base currency. In an indirect quote, the domestic currency is the quoted currency.

Nearly all currency exchange rate quotes are carried out to four digits after the decimal place. An important exception is the Japanese yen, which is carried out to two decimal places.
Cross Currency
A cross currency is a currency quote that doesn't have the US dollar as one of its components. Common cross currency pairs include EUR/JPY, EUR/GBP and EUR/CHF. Although these currency pairs aren't as actively traded as pairs that include the US dollar, they do expand currency tradersf options in the Forex market.

Trading a Currency
When trading a currency pair there is a bid price and an ask price. When going long or buying a currency pair, the ask price is the amount of the quoted currency to be paid in order to buy one unit of the base currency.

When going short or selling a currency pair the bid price is how much of the quoted currency will be obtained when selling one unit of the base currency.

The bid price is the quote before the slash. The last two digits after the slash are the ask price. Often, only the last two digits of the full price or quoted. Generally, the bid price is smaller than the ask price. Here's an example:

USD/CAD=1.0000/05
Bid=1.0000
Ask=1.0005

Let's say that you wanted to buy this currency pair. In other words, you plan to buy the base currency and are watching the ask price to determine how much in Canadian dollars the market charges for US dollars. According to the example, one US dollar can be bought for 1.0005 Canadian dollars.

Now let's say you wanted to sell this currency pair. In other words, you plan to sell the base currency in exchange for the quoted currency. In this case, you would look at the bid price. According to the bid price, the market will buy one US dollar for 1.0000 Canadian dollars.

Transactions are conducted in whichever currency is quoted first. In other words, transactions are conducted in the base currency. You purchase the base currency or sell the base currency.

Pips and Spreads
A pip can be defined as the smallest amount that a price can move in a currency quote. A spread is the difference between the bid price and the ask price. Here's the previous example again:

USD/CAD=1.0000/05

In this case the spread would be 0.0005 or 5 pips. Pips are also sometimes called points. One pip equals 0.0001 units when talking about US dollars, British Pounds, Swiss Franc, or Euro. One pip equals 0.01 units when talking about the Japanese yen.

Currencies are quoted differently on the forwards and futures markets. Foreign exchange is quoted against the US dollar in the forwards and futures markets. In other words, pricing shows how many US dollars you need to buy one unit of a given foreign currency. This contrasts with the spot market where in some cases currencies are quoted against the US dollar and in other cases the US dollar is quoted against the foreign currency.

Forex versus Equities
The Forex market has very few traded instruments. This is a major difference between the Forex market and the equities markets. The equities market has thousands of stocks for traders to research and choose from, however most Forex trades revolve around seven major currency pairs. The seven major pairs are USD/JPY, GBP/USD, EUR/USD, USD/CHF, USD/CAD, NZD/USD and AUD/USD.

In the equities market it is sometimes difficult for traders to make money when the market declines. There are specific rules and regulations regarding short-selling US equities. However in the Forex market traders have the opportunity to profit in either rising or declining market. In the Forex market, short-selling is inherent in every transaction because traders are buying and selling simultaneously. Also, the Forex market is generally more liquid than the equities market so traders don't have to wait for an uptick before they enter

  a short position.
Margins are low and leverage is high on the Forex market, a result of its high level of liquidity. Such low margin rates are extremely difficult to find in the equities markets, where margin traders often need to maintain at least 50% of the value of the investment as margin. Forex traders on the other hand sometimes need only 1% equity. Commissions in the Forex market tend to be lower than in the equities market.

History of Currency Exchange
The gold standard monetary system was created in 1875. It was one of the most important events in the history of the Forex market. Previously, countries used to use gold and silver to make international payments. However, the value of gold and silver was affected by external supply and demand, which created problems. For example, if a new gold mine was discovered the price of gold would go down.

With the gold standard governments around the world agreed that they would convert currency into specific amounts of gold. To do this governments were required to have large gold reserves to meet the demand to make exchanges. By the end of the 19th century, most of the countries with large economies had defined a certain amount of currency as being equal to one ounce of gold. As time went on, the amount of each currency that was required to purchase one ounce of gold became exchange rates between two currencies. This was the beginning of currency exchange.

Around the beginning of World War I the gold standard broke down. European powers believed it was necessary to complete large military projects because of political pressure from Germany. The cost of these military projects was so high that there wasn't enough gold to exchange for all the currency that the governments were printing.

The gold standard returned briefly after World War I, however most countries went off the gold standard again before World War II.

Near the end of World War II the Allied nations decided to set up a monetary system to replace the gold standard. Over 700 Allied representatives met in Bretton Woods, New Hampshire, in July of 1944 to discuss the Bretton Woods system of international monetary management. Some of the main ideas that came out of the meeting were that the US dollar would replace the gold standard and become a primary reserve currency, that there would be fixed exchange rates and that there would be three international agencies to oversee economic activity would be created. These agencies were the international monetary fund (IMF), the General Agreement on Tariffs and Trade (GATT), and the International Bank for Reconstruction and Development.

The US dollar replacing gold as the primary standard for world currency conversions was one of the main ideas brought about by Bretton Woods. At the time the US dollar was the only currency that was backed by gold.

Over the next few decades, in order to remain the world's reserve currency, the United States had to have a series of balance of payment deficits. However, in the early 1970s, US gold reserves had become so depleted that the United States treasury lacked enough gold to cover the large number of US dollars that foreign central banks had in reserve. So on August 15, 1971, the United States effectively declared that it would no longer exchange gold for US dollars that were held in foreign reserves when US President Richard Nixon closed the gold window. President Nixon's actions brought the Bretton Woods system to an end.

In 1976, the world decided to use floating foreign exchange rates in what was called the Jamaica agreement. This agreement abolished the gold standard. However, not all governments have adopted a free floating exchange rate system. In fact, most governments still use one of three exchange-rate systems. They are Dollarization, a pegged rate, and managed floating rate.

Dollarization occurs if a country chooses to not issue its own currency and instead uses of foreign currency as its national currency. One advantage of dollarization is that the country may be seen as a relatively stable place for investment. Two disadvantages of dollarization are that the country's central bank can no longer make monetary policy nor print money.

Pegged rates happen if a country chooses to directly fix its exchange rates to a foreign currency. Pegged rates usually allow the country to have more stability than a normal float. The country's currency may be pegged at a fixed rate to a single currency or to a specific basket of foreign currencies. The currency only fluctuates when there are changes in the pegged currencies. An obvious example of a pegged currency is the Chinese yuan. Between 1997 and July 21, 2005 the Chinese Yon was pegged to the US dollar at a rate of 8.28 yuan.

Managed floating rates are created when a country's exchange rate changes freely and the currencyf value is subject to the forces of supply and demand in the market. With managed floating rates the country's central bank or government may intervene when there are extreme fluctuations in exchange rates. If, for example, a country's currency depreciates too much, the government could increase short-term interest rates, which would likely cause the currency to appreciate. Central banks generally have a wide variety of tools that they can use to manage their currency.

Participants in the Forex Market

Market participants in the equities market are often limited to investors who trade with either other investors or institutional investors like mutual funds. On the Forex market, however, there are market participants who are not investors.

Governments and central banks are probably the most influential participants in the currency exchange market. Many countries use their central banks as an extension of the government to conduct monetary policy. Other countries seem to believe their central banks would be more effective in finding a balance between keeping interest rates low and curbing inflation if they were more independent, and free of government control. In both cases, though, representatives from the government usually have regular meetings and discussions with the representatives of the central banks, leading, often, to similar ideas on monetary policy.

Reserve volumes are often manipulated by central banks in attempts to meet economic goals. China, for example, has been purchasing millions of dollars of United States treasury bills to keep the Chinese Yuan at its target exchange rate, a result of China pegging its currency to the US dollar. Central banks adjust their reserve volumes by participating in the foreign exchange market. Because these banks have a great deal of purchasing and selling power, they have a large influence on the direction of the currency markets.

Banks and other financial institutions are some of the largest participants in Forex transactions. The interbank market is where large banks conduct transactions amongst themselves. These transactions determine the currency. The interbank market is huge in volume when compared to the exchange individuals make when they need small-scale foreign currency transactions. Credit is the basis of the electronic brokering systems that allow the banks to transact with each other. The only banks that can engage in transactions are ones that have great relationships with each other. Larger banks generally have a wider array of credit relationships and therefore can access better pricing for their customers. On the other hand, small banks with fewer credit relationships often have lower priority in pricing. We can think of banks as being dealers because they are willing to buy or sell a currency at the ask or bid price. Banks are able to make money by charging a premium to exchange currency on the Forex market. The Forex market is decentralized so frequently different banks have slightly different exchange rates for a given currency.

 According to TeachMeFinance.com