Finance The creation and management of money
Capital Budgeting The process of planning and managing a firm’s long term investments; Financial manager tries to identify investment opportunities that are worth more to the firm than the cost to acquire; Evaluates SIZE, TIMING, and RISK of future cash flows
The Big 3 Econ (supply and demand), Accounting (record keeping), and Finance (cash flows)
Goals of Finance Promotions, speak the language, new opportunities, move into upper level management
4 areas of Finance Corporate Finance, Investments, Financial Institutions, International Finance
Corporate Finance Business Finance
Investments Area (and career opportunities) Deals with financial assets such as stocks and bonds; Career opportunities: Stockbrokers, Portfolio management, Security or treasury bill analyst, Financial advisor
Financial Institutions (and career opportunities) Banks/Insurance Companies; Career opportunities: Commercial loan officer at a bank, insurance risk manager
Decisions financial managers face Capital Budgeting, Capital Structure, Working Capital Management
Sole proprietorship Business owned by one person; unlimited liability, all business income is taxed as personal income
Partnership Two or more owners; all partners share in gains or loses and have unlimited liability for debts; with a limited partnership, one more more limited partners will not actively participate in the business, and their liability for business debts is limited to the amount they contribute to the partnership
Corporation Legal “person” separate and distinct from its owners, and has many of the rights, duties, and privileges of an actual personAdvantages: Separation of ownership and management, limited liability (owners only lose what they have invested)Disadvantages: Double taxation
Limited Liability Company (LLC) Operate and taxed like a partnership but retains limited liability for owners
Agency Relationships Relationship between stockholders and management; principle hires the agent to represent his or her interest
Sarbanes Oxely Act (SARBOX) 2002, created to combat corporate scandals (prevent financial fraud, accounting scandals, malpractice)
“Go Dark” Companies pulled out of the US market in response to SARBOX and went to the European market
Accounting Prepares financial statements
Balance Sheet A snapshot of any given day of a firm’s assets and liabilities; serves as a means for summarizing and organizing what a firm owes (liabilities) and what it owns (assets)
Order of assets on balance sheet Listed in decreasing order of liquidity
Liquidity How quickly something can be sold or turned into cash
Current Assets Lifespan of 1 yr or less (inventory, accounts receivable)
Fixed Assets Lifespan of 1 yr or more (Tangible, Intangible such as Patent or Trademark)
Current Liabilities Payed within 1 yr or less (accounts payable)
Long Term Debt Payed within 1 yr or more (mortgage)
Total Assets = ? Total liabilities + Owners Equity
Working Capital Refers to a firm’s current assets and current liabilities; day to day activities that ensures a firm has sufficient resources to continue its operations and avoid costly interuptions
Net Working Capital CA – CL (always positive in a healthy firm)
Highly Liquid Items Cash, Gold
Low Liquid Items Custom Manufacturing Facility (No one will want to buy it because no one else needs it)
Debt Creates financial leverage by allowing businesses and individuals to do more and grow
Income statement Measures performance over a specific period (usually quarters)
Marginal Tax Percentage of tax paid on the next whole dollar of income (if you made 8926 during the year, 8925 would be taxed at 10% and 1 would be taxed at 15%)
Marginal Tax Example: $50,000 8925 (.10)27325 (.15)50000-36250 = 1375013750 (.25) = 8428
Average Tax Total tax bill / taxable income; what you end up paying percentage wise on each dollarIf you had a taxable income of 200,000 and the tax bill was 61250, 61250/200000= 30.625%
Income Statement Net sales- Cost of goods sold- Depreciation_________EBIT- Interest paid_________Taxable income- Taxes_________Net income
Matt and Alicia created a film that is a separate legal entity and will share ownership of that firm on a 50/50 basis; Which type of entity did they create if they have no personal liability for the firm’s debts? Corporation
Jenna has been promoted and is now in charge of all external financing. In other words, she is in charge of… Capital Structure Management
Capital budgeting includes the evaluation of what? Size, timing, and risk of future cash flows
An agency issue is most apt to develop when… The control of a firm is separated from the firm’s ownership (because they’ll have different interests)
In what year was SARBOX enacted by congress? 2002
In what year did key elements of SARBOX take effect? 2004
Primary benefits of S corporations Avoids double taxation
When reviewing a balance sheet, assets are listed from top to bottom in order of… Decreasing liquity
When reviewing a balance sheet, liabilities are listed from top to bottom in order of… Next due to be paid
The financial statement that summarizes a firm’s accounting value as of a particular date is called the… Balance sheet
A firm decides to make a decision that decreases their liquidity. What decision did they make?A. Cash purchase of InventoryB. Credit sale of InventoryC. Cash sale of InventoryD. Collection of an account receivableE. Proceeds from a long-term loan If they decrease their liquidity, it means that assets are less easily converted into cash. A. Cash purchase of InventoryThey got rid of their cash, which means they decreased their liquidity.
Production equipment is classified as:A. A net working capital itemB. A current liabilityC. A current assetD. A tangible fixed assetE. An intangible fixed asset A tangible fixed asset
Over the past year, a firm decreased its current assets and increased its current liabilities. As a result, the firm’s net working capital… Had to decrease
EPS measures the net income with respect to:A. The dividends paid to each shareholderB. The profit or loss for each share of stockC. Total profits or lossesD. Minimum earningsE. Gross profit EPS = Net income / total shares outstandingB. The profit or loss for each share of stock
The amount of tax paid on the next whole dollar of income refers to which type of tax? Marginal tax
Common size statements Standardized financial statement presenting all items in percentage terms; balance sheet items are shown as a percentage of assets and income statement items as a percentage of sales
Financial ratios Relationships determined from a firm’s financial info and used for comparison purposes
Problem with financial ratios Dif people and dif sources frequently don’t compute them in exactly the same way, which leads to confusion
Short term solvency, or liquidity ratios Intended to provide info about a firm’s liquidity; firms ability to pay its bills over the short run; focuses on current assets and current liabilities
Types of short term solvency ratios (3) Current Ratio (measure of short term liquidity, the higher the better), Quick Ratio (measures liquidity without inventory), Cash ratio
Long term solvency, or financial leverage ratios Addresses the firm’s long run ability to meet its obligations, or its financial leverage
Types of long term solvency ratios (5) Total debt ratio (all debts of all maturities to all creditors), debt-equity ratio, equity multiplier, Times Interest Earned ratio, Cash Coverage ratio
Asset Management, or Turnover Ratios Intended to describe how efficiently a firm uses its assets to generate sales
Types of asset management ratios (3) Inventory turnover (how often you sell off inventory in a year, or how fast you can sell products)Receivables turnover (How fast you collect on sales, or how many times you collect outstanding credit accounts in a year)Total Asset Turnover (For every dollar in assets, how much you generate in sales)
Big Picture Ratio Total Asset Turnover
Profitability Ratios Measures how efficiently the firm uses its assets and how efficiently the firm manages its operations
Types of profitability ratios (3) Profit margin (how much profit it generates for every dollar in sales)Return on assets (measure of profit per dollar of assets)Return on equity (measure of profit per dollar of equity, aka how the stockholders fared during the year)
Market Value Ratios How the market values a firm
Types of market value ratios PE Ratio (how much investors are willing to pay per dollar of current earnings)Market to book ratio (compares market value of the firm’s investments to their cost, aka how much value the stock holds)
Du Point Identity Prof margin x total asset turnover x equity multiplierBreaks ROE into three parts:- Operating efficiency (as measured by profit margin)- Asset use efficiency (as measured by total asset turnover)- Financial Leverage (as measured by equity multiplier)
Time value of money A dollar in hand today is worth more than a dollar promised at some point in the future
Simple Interest Earns interest only on original principle ex. $100, 10% interest for 2 years100 x .10 = 10, so you earn 10 dollars every year
Compound Interest Interest is earned on principle + interestex. $100, 10% interest for 2 yearsYr 1 – 100 x .10 = 110Yr 2 – 110 x .10 = 121
If a firm has an inventory turnover of 15, what does that mean? The firm sells its entire inventory on average of 15 times each year
Which one of the items below is not one of the 5 questions to ask oneself about ratios?A. What is the unit of measurement?B. What is it intending to measure?C. How is it computed?D. What is it telling us about the future?E. What might a high or low value be indicating? What is it telling us about the future?
Which of the following will increase the profit margin of a firm, all else held constant?A. Increase in interest paidB. Increase in fixed costsC. Increase in depreciation expenseD. Decrease in tax rateE. Decrease in sales Decrease in the tax rateProfit Margin = Net Income / Sales
How to increase or decrease a ratio (in regards to numerator and denominator) Numerator = direct relationshipDenominator = inverse relationshipIncreasing the numerator = Higher numberDecreasing the numerator = Lower numberIncreasing denominator = Lower numberDecreasing denominator = Higher number
Smith and Son’s company has a current ratio that is average in comparison to their industry. However, their quick ratio is significantly lower than their industry average. What can be concluded from this?Current Ratio = CA / CLQuick Ratio = CA – Inventory / CL They have a higher inventory than the industry average
The wood shop generates .97 in sales for every 1 invested in total assets. Which ratio would reflect this relationship? Total asset turnover
The relationship between the present value and the investment time period is best described as:A. DirectB. InverseC. UnrelatedPv = Fv / (1 + r) ^ t Inverse
The future value of a lump sum investment will increase if you…A. Decrease interest rateB. Decrease number of compounding periodsC. Increase time periodD. Decrease time periodE. Decrease lump sum amountFv = Pv x (1 + r) ^t Increase the time period
Which one of the following will increase the present value of a lump sum future amount to be received in 15 years?A. Increase in time periodB. Increase in interest rateC. Decrease in future valueD. Decrease in interest rateE. Changing to compound interest from simple interestPv = Fv / (1 + r) ^ t Decrease the interest rate
Given an interest rate of 0, the future value of a lump sum invested today will always:A. Remain constant, regardless of the investment time periodB. Decrease if the investment time period is shortenedC. Decrease if the investment time period is lengthenedD. Be equal to 0Fv = Pv x (1 + r) ^t Remain constant, regardless of the investment time period
Jamie earned 14 in interest on her savings account last year. She has decided to leave the 14 in her account so that she can earn interest on the 14 this year. The interest earned on last year’s interest earnings is called:A. Simple interestB. Complex interestC. Accrued interestD. Interest on interestE. Discounted interest Interest on interest
Rule of 72 Years to double = 72/Interest Rate
Discounted cash flow valuation (DCF) Calculating the present value of a future cash flow to determine its value today; A valuation method used to estimate the attractiveness of an investment opportunity
Cash Flow Either an inflow or outflow of money at a specific point in time; Unless stated, outflows always happen at the end of the period
Annuities Finite series of equal payments at regular intervals
Ordinary annuity Payment occurs at end of period (most common)
Annuity due Payment at beginning of period (Rent, Scholarships)
Perpetuity Infinite series of equal payments at regular intervals (life insurance)
EAR- Effective Annual Rate – Expressing interest as if compounded once per year- Always higher than APR- Used when making money
APR – Annual Percentage Rate – The interest rate charged per period multiplied by the number of periods per year- Also called Nominal Rate- Annual rate quoted by law- Used when paying interest – Always lower than EAR- Ex. If you get a 12% APR credit card, you’re paying 1% per month
3 types of loans Pure Discount LoanInterest Only LoansAmortized Loans
Pure Discount Loan Borrower receives money today, repays with single lump sum and interest at end of loan
Interest Only Loan Borrower pays interest each term and the principal back at the end Ex. $1000, 10% interest, 3 yearsYr 1 – 100Yr 2 – 100Yr 3 – 100 + 1000
Amortized loans Combo of principal + interest paid back all at once over loan terms
Bond When a company wishes to borrow money from the public it issues (sells) debt securities, called bonds. They promise to pay back later.
What type of loan is a bond? Interest only loan (Interest payments are made each year, and 1000 is payed back at the end)
Why buy bonds? Slow, steady, and predictable returnsBetter than bank
How bonds are bought – Over the counter- Broker/Dealer
Bid-Ask Spread Bid Price- What a dealer is willing to payAsk price- What the dealer is willing to acceptThe difference between these two prices is the bid-ask spread
Primary vs Secondary market (Bonds) Primary – New BondsSecondary – Used Bonds
Fischer Effect Named after Irwin Fischer; Investors don’t care about return %, only about what they can buy with their returns, so you need to account for inflationAka the relationship between nominal rates, real rates, and inflation
Real rates Interest rates that have been adjusted for inflation
Nominal rates Interest rates that have not been adjusted for inflation
Inflation premium Investors demand compensation for the loss due to inflation in the form of higher nominal rates
Interest rate risk premium Longer term bonds have greater risk of loss resulting from changes in interest rates; Investors recognize this risk and they demand extra compensation in the form of higher rates for bearing itThe longer the term to maturity, the greater the interest rate risk, so the interest rate risk premium increases with maturity
4 types of bonds Corporate, Government, Municipal, Foregin
Corporate Bonds Backed by company’s ability to pay through future earnings; Sometimes companies back bonds using assets as collateral
Government Bonds Issued to promote government spendingTreasury Bond – 10+ yrsTreasury Note – 1-10 yrsTreasury Bill – Less than 1 yrNo default risk, only taxed at federal level
Municipal Bonds Bonds issued by the city; exempt from taxationGeneral Obligation Bonds (Backed by taxing power)Revenue Bonds (Projects)Varying degrees of default risk, very attractive to high income investors due to the tax break
Foreign Bonds Could be corporate, government, or municipal; Very risky
Maturity The date upon which the principal amount of a bond is repaid
Indenture The bond agreement between the bond issuer and the bond holder
Debenture Unsecured debt with bond terms of 10 or more years
Note Unsecured debt with terms of 10 years or less
Bearer Form No record of ownership
Registered form Issuer maintains record of ownership
Call provision Provision of bonds, issuer can buy back at specific price, prior to maturity
Deferred call provision Stipulates the buy pack date (cannot buy back any earlier)
Zero coupon bonds Sold at a deep discount, pay 0 in coupons
Par Value (Face Value) Amount repaid at the end of the bond
Floating rate coupon Adjustable interest rate
Bond ratings AAA, AA, A – D, based off Standard and Poors and Moodys
Investor Grade Bond Rating B or higher
Miller Farm Products is issuing a 15 yr unsecured bond. Based on this info, this debt is what? Debenture
Bond trader just purchased and resold a bond. The amount of profit earned by the trader from this purchase and resale is… Bid-Ask Spread
The rate of return an investor earns on a bond prior to adjusting for inflation is called the… Nominal rate
All else held constant, the present value of a bond increases when the…A. Coupon rate decreasesB. Yield to maturity decreasesC. Current yield increasesD. Time to maturity of a premium bond decreasesE. Time to maturity of a zero coupon bond increases Yield to maturity decreases
Which of the following individuals s most apt to purchase a municipal bond?A. Minimum wage employeeB. Retired individual with minimal incomeC. Recent college gradD. Tax exempt organizationE. Highly compensated business owner Highly compensated business owner
When comparing savings accounts, you should select the account that has the…A. Lowest APRB. Highest APRC. Highest stated rateD. Lowest EARE. Highest EAR Highest EAR
Lee pays 1 percent per month interest on his credit card account. When his monthly rate is multiplied by 12, the resulting answer is referred to as the…? Annual Percentage Rate
The market required rate of return on a bond that is held for its entire life is called the… Yield to maturity
Stock Market An equity market where shares of publicly held companies are issued and traded
Stock market hours 9:30-4 M-F
Two types of stock Common Stock, and Preferred Stock
Common Stock Ownership without priority for dividends- Voting privileges- Proxy voting
Preferred Stock Dividend Priority over common stock- Normally has a fixed dividend- No voting rights- Either cumulative or noncumulative dividends (need to make good on all past dividends or can skip any years missed and only pay current dividends)
Stock Classes Class A available to the public, class B available to employees
Stock splits Taking every share that somebody owns and splitting it into several stocks when prices are too high (Person had 1 share for $10, but now has 10 shares for $1)
Reverse stock splits Person had 10 shares for $1, but now has 1 share for $10
Full service broker Extremely useful for their expertise and advise, very expensive
Online/Discount Broker No advice, do it yourself; Less expensive
New York Stock Exchange (NYSE) Used to sell seats for 4 million dollars, now that it’s public it sells licenses for 40,000 a year
When did the NYSE become public 2006
Roles in the NYSE Dealers (have their own inventory of stocks) and brokers (no inventory; connect buyers with sellers)
Types of License holders in the NYSE Specialist Dealer or Designated Market Maker, Floor Broker, Floor Trader or Supplemental Equity Providers
Specialist Dealer or Designated Market Maker Have their own number of stocks that they trade on the floor
Floor Broker Execute orders for customers; goal is to get the best price
Floor Trader or SLP People who trade their own accounts for profit (look for price fluctuations, try to make trades before the majority catches on)
NASDAQ Online Platform
Why stocks are more difficult to value than bonds No promise of cash flows known in advance, life of investment is forever (until you sell it), no way of knowing the return on the market
How to we evaluate stocks Look at cash flows from capital gains, cash flows from dividends (whether they’re steady, increasing, or decreasing)
4 types of capital budgeting projects Expansion, Improvements, Replacements, Government Mandated
Payback Method Time required for an investment to generate cash flows to cover initial costs; Get Your Bait Back methodRule: Take on project if payback is less than the cut off point
Payback Advantages and Disadvantages Best used for short run decisionsEasiestCan adjust for future cash flowsBiased toward liquidityIgnores TMVBiased toward longer projects
Net Present Value Method The difference between a project’s market value and its costRule: If NPV is positive, accept project
NPV Advantages and Disadvantages Best method in principleArbitrary growth rateRisk not considered
Internal Rate of Return Method Discount rate at which makes NPV of an investment zeroRule: Accept if IRR is the same or greater than the return required by investors
The capital gains yield equals what?A. Total yieldB. Current discount rateC. Market rate of returnD. Dividend yieldE. Dividend growth rate Dividend Growth Rate
The owner of a trading license who trades on the floor of the NYSE for his or her own personal account is a… Supplemental Liquidity Provider (or floor trader)
Net present value involves discounting an investment’s… Future cash flows
If an investment is producing a return that is equal to the required return, the investment’s net present value will be… 0
Payback is best used to evaluate which type of project?A. Low cost, short termB. High cost, short termC. Low cost, long termD. High cost, long termE. Any size Low cost, short term
Risk and Return As the level of risk increases, so does the potential for higher (or lower) returns
Risk tolerance Preference towards risk (usually young people have a higher pref towards risk)
Return of bonds Don’t make nearly as much with bonds as you do with stocks; treasury bonds are not much more than inflation
Capital gains/losses The income made or lost on the sale of a stock
Capital gain/loss equation Shares x (sell price – buy price)
3 reactions to new info on stock market Efficient market reaction (price instantaneously jumps to a new higher/lower price and remains there), over reaction and correction, delayed reaction (adjusted slowly to new price, usually in 8 days)
Efficient market hypothesis Markets will continuously adjust to reflect new info if they are efficient
Risk The potential of losing something of value, weighted against the potential of gaining something of value
Expected returns The return of a risky asset, expected in the future
2 types of risk Systematic and unsystematic risk
Systematic risk A risk that influences a large number of stocks, also called “market risks”; Macro economic factors
Unsystematic risk A risk that influences a specific firm or industry, microeconomic factors
Total risk Systematic + unsystematic risk
Systematic risk principle The expected return on a risky asset depends only on that asset’s systematic risk (not on its unsystematic)
Principle of diversification Spread investments over a number of assets to eliminate some unsystematic risk, but it will not eliminate systematic risk
Portfolio A group of assets (such as stocks or bonds) held by investors. Ex. 401k
Beta Amount of systematic risk present in a particular risky asset, relative to the average asset. Average Beta = 1, 2 = Twice the risk
Market forms Weak form, semi strong form, and strong form
Weak form Efficient If a stock’s price only reflects history of its past prices, it is said to be weak form efficient
The lower the standard deviation of returns on a security, the ______ the expected rate of return and the ______ the risk Lower; Lower
Which one of the following had the second highest distribution of returns for the period 1926 – 2014?Long term gov bondsGlobal StocksLarge Company StocksSmall Company Stocks Large Company Stocks (followed by small company stocks, because they carry the most risk)
Which one of the following had the least negative returns for the period 1926-2014?Treasury BillsLong term government bondsInflationSmall company stocksLarge company stocks Treasury bills
Semi Strong Form Market Efficienty The value of a security is based on all publicly available information
A stock is expected to return 13 percent in an economic boom, 10 percent in a normal economy, and 3 percent in a recessionary economy. Which one of the following will lower the overall expected rate of return on this stock? A decrease in the probability of an economic boom
Cost of equity For every 1 dollar we raise in equity, how much we pay investors
Cost of preferred stock The return preferred stock investors require on their investment in the firm
Cost of debt The return lenders require on a firm’s debt
Weighted average cost of capital Weighted average of the cost of equity (common and preferred stock) and the after tax cost of debt
Cash is… King
Short term financing Making sure there is enough cash on hand, because without enough cash on hand many business can fail
Cash equation Long term debt + equity + current liabilities – Current assets (other than cash) – Fixed assets
How to increase cash Increase liabilities
How to decrease cash Increase assets
Activities that increase cash Increase LTD, Increase Equity, Increase CL, Decrease CA, Decrease FA
Activities that decrease cash Decrease LTD, Decrease Equity, Decrease CL, Increase CA, Increase FA
Operating cycles and cash cycles Evaluates how products and money move through a company
If you purchase inventory on credit, what happens to cash? Liabilities increase, Assets increase, so NO IMPACT
If you pay for the inventory, what happens to cash? Liabilities decrease, so CASH DECREASES
If you sell inventory on credit, what happens to cash? Liabilities increase Assets decrease, so NO IMPACT
Cash flow timeline Line graph representing the operating and cash cycles
Operating cycle The time between acquiring inventory and collecting on the sale
Inventory period Time between acquiring inventory and selling it
Accounts Recievable Time between selling inventory and collecting payment on it
Accounts Payable Time between receiving inventory and paying for it
Cash Cycle Time between inventory purchase and collecting payment on sold goods
Cash budget Primary tool in financial planning for managers to estimate cash in and cash out of the company to determine any short term surplus or deficits, to see if any short term financing is needed
Cash collection for 45 days receivables Beginning Accounts Receivable + 1/2 x sales
Cash collection for 60 days receivables Beginning Accounts Receivable + 1/3 x sales
Cash collection for 30 days receivables Beginning Accounts Receivable + 2/3 x sales
Short term borrowing If a company finds they are in a cash deficit, they can borrow cash short term
2 types of short term loans Unsecured and secured
Unsecured loans No collateral, most commonLine of creditRevolving credit arrangement
Secured loans CollateralAccounts receivable financingInventory loans
Line of credit A firm borrows and is authorized to borrow up to a certain amount, usually for a period of 1 year. Sometimes requires to pay down to $0 for a period of time, usually 60 days is known as the clean up period
Requiring to pay down to 0 for 60 days is known as the… Clean up period
Forms of lines of credit Committed and non-committed
Committed line of credit Formal, often involves a commitment fee paid to bank with a floating interest rate
Non committed line of credit Informal, borrowers can reborrow previously specified limits without redoing paperwork
Revolving credit arrangement Also called a revolver, similar to lines of credit but usually for 2+ years
Accounts receivable financing Lender is entitled to receivables as a security; seen with secured loans
Inventory loans Lender finances firm to purchase inventory; Seen with secured loans
How many currencies in the world Over 160
Why do companies do business abroad Less expensive, opportunities to grow business into other countries
Companies that operate abroad are called…. International corporations or multi nationals
International financial factors to consider (5) Dif exchange rates, dif interest rates, complex and varying accounting methods, foreign tax rates, foreign government intervention
Importers Pay for goods in foregin currency
Exporters Receive foreign currency for goods and often convert to their domestic currency
Porfolio managers buy and sell foreign stock
Foreign exhcnage brokers Match buy/sell orders
Traders Make a market in foregin currency
Speculators Try to make a profit from inconsistencies in exchange rates (very hard)
American depository receipt (ADR) Security issued in the US representing shares of foreign stock
Company sponsored ADR On stock exchange
Unsponsored ADR Held by an investment bank
Exchange rates The price of one currency expressed in terms of another country’s currency
Gilts British and irish government securities
Currency swap agreement to dilver one currency in exchange for another
Foreign exchange Market (FOREX) The market in which one country’s currency is traded for another; worlds largest financial market; OTC, no single location where traders come together, participants are located in major commercial and investment banks around the world, doing their work by phone and computer; only operates on a few currencies (dollar, pound, yen, and euro)
Spot trade Transaction complete within 2 business days
Spot exhcnage rate The exchange rate on a spot trade
Forward trade An agreement to exchange currency at some time in the future, agreed upon today, normally settled within the next 12 months
Forward exchange rate The exchange rate agreed upon in the forward trade
Purchasing Power Parity (PPP) The idea that exchange rates adjust to keep purchasing power constant among currencies (things should cost the same)
Absolute purchasing pwoer parity A commodity should cost the same regardless of what currency is used to purchase it
Commodity Things that are exactly the same (red apple and red apple, not red apple and green apple)
What needs to happen for purchasing power to hold true? Transaction costs, such as shipping, insurance, and spoilage must be zero. There must also be no barriers to trade like taarrifs, taxes, or political barriers.
Traingular arbitrage The process of converting currencies through 2 or more currencies and then back to the original currency, for the purpose of profit from inconsistencies in exchange rates.
Currency swap agreement to dilver one currency in exchange for another

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