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1 Managing Your Money C H A P T E R 6 a haircut. With $110 to spend, Sandra wrote seven checks totaling $90. Unfortunately for Sandra, she made a math error in entering one of her checks into her checkbook register. She was off by $100. Instead of $110 available, her real balance is $10. Alerted by the bank that her first check had bounced, Sandra borrowed $100 from a friend and deposited it into her account. Unfortunately, she did not realize that each bounced check incurred a penalty fee of $15. After depositing the $100 from her friend, Sandra s account was still $85 short due to $105 worth of penalty fees! Sandra lives from paycheck to paycheck. She always seems to run out of money near the end of the month, but this month, she is ahead. In her checkbook register she still has $110. Now Sandra also has another habit that, combined with a careless mistake, could cost her financially. Sandra always writes small checks. They might be $15 for gas, $5 for lunch, or $40 for This expensive lesson for Sandra could have been avoided if she had requested overdraft protection on her account or used a debit card. The overdraft protection would have saved her from penalty fees, albeit at the cost of interest charged on the overdraft loan. A debit card would have protected her from bouncing checks by alerting her to the actual status of her checking account balance. 159

2 160 M A N A G I N G Y O U R M O N E Y In addition to describing techniques for managing your checking account, this chapter will identify the various types of money market investments and explain how the use of cash management can lead to increased liquidity within your financial plan for expected and unexpected expenses. The objectives of this chapter are to: provide a background on money management, describe the most popular money market investments, identify the risk associated with money market investments, and explain how to manage the risk of your money market investments. money management A series of decisions made over a short-term period regarding cash inflows and outflows. BACKGROUND ON MONEY MANAGEMENT Money management describes the decisions you make over a short-term period regarding your cash inflows and outflows. It is separate from decisions on investing funds for a long-term period (such as several years) or borrowing funds for a long-term period. Instead, it focuses on maintaining short-term investments to achieve both liquidity and an adequate return on your investments, as explained next. liquidity Your ability to cover any cash deficiencies that you may experience. LIQUIDITY As discussed in Chapter 1, liquidity refers to your ability to cover any shortterm cash deficiencies. Recall that the personal cash flow statement determines the amount of excess or deficient funds that you have at the end of a period, such as one month from now. Money management is related to the personal cash flow statement because it determines how to use excess funds, or how to obtain funds if your cash inflows are insufficient. You should strive to maintain a sufficient amount of funds in liquid assets such as a checking account or savings account to draw on when your cash outflows exceed your cash inflows. In this way, you maintain adequate liquidity. Some individuals rely on a credit card (to be discussed in detail in Chapter 7) as a source of liquidity rather than maintaining liquid investments. Many credit cards provide temporary free financing from the time you make purchases until the date when your payment is due. If you have insufficient funds to pay the entire credit card balance when the bill is due, you may pay only a portion of your balance and finance the rest of the payment. The interest rate is usually quite high, commonly ranging from 8 to 20 percent. Maintaining liquid assets that you can easily access when you need funds allows you to avoid using credit and paying high finance charges.

3 MONEY MARKET INVESTMENTS 161 EXAMPLE Stephanie Spratt s cash inflows are $2,500 per month after taxes. Her cash outflows are normally about $2,100 per month, leaving her with $400 in cash each month. This month she expects that she will have an extra expense of $600; therefore, her cash outflows will exceed her cash inflows by $200. She needs a convenient source of funds to cover the extra expense. Liquidity is necessary because there will be periods when your cash inflows are not adequate to cover your cash outflows. But there are opportunity costs when you maintain an excessive amount of liquid funds. A portion of those funds could have been invested in less liquid assets that could earn a higher return than, say, a savings account. In general, the more liquid an investment, the lower its return, so you forgo higher returns when maintaining a high degree of liquidity. ADEQUATE RETURN When you maintain short-term investments, you should strive to achieve the highest possible return. The return on your short-term investments is dependent on the prevailing risk-free rate and the level of risk you are willing to tolerate. Some assets that satisfy your liquidity needs may not necessarily achieve the return that you expect. For example, you could maintain a large amount of cash in your wallet as a source of liquidity, but it would earn a zero rate of return. Other investments may provide an adequate return, but are not liquid. To achieve both liquidity and an adequate return, you should consider investing in multiple money market investments with varied returns and levels of liquidity. MONEY MARKET INVESTMENTS Common investments for short-term funds include the following money market investments: Checking account NOW account Savings deposit Certificate of deposit Money market deposit account (MMDA) Treasury bills Money market fund Asset management account

4 162 M A N A G I N G Y O U R M O N E Y All of these investments except Treasury bills and money market funds are offered by depository institutions and are insured for up to $100,000 in the event of default by the institution. In this section, we ll examine each of these investments in turn, and focus on their liquidity and typical return. CHECKING ACCOUNT Individuals deposit funds in a checking account at a depository institution to write checks or use their debit card to pay for various products and services. A checking account is a very liquid investment because you can access the funds (by withdrawing funds or writing checks) at any time. overdraft protection An arrangement that protects a customer who writes a check for an amount that exceeds the checking account balance; it is a short-term loan from the depository institution where the checking account is maintained. stop payment A financial institution s notice that it will not honor a check if someone tries to cash it; usually occurs in response to a request by the writer of the check. Overdraft Protection. Some depository institutions offer overdraft protection, which protects a customer who writes a check for an amount that exceeds the checking account balance. The protection is essentially a short-term loan. For example, if you write a check for $300 but have a checking account balance of only $100, the depository institution will provide overdraft protection by making a loan of $200 to make up the difference. Without overdraft protection, checks written against an insufficient account balance bounce, meaning that they are not honored by the depository institution. In addition, a customer who writes a check that bounces may be charged a penalty fee by the financial institution. Overdraft protection s cost is the high interest rate charged on the loan. Stop Payment. If you write a check but believe that it was lost and never received by the payee, you may request that the financial institution stop payment, which means that the institution will not honor the check if someone tries to cash it. In some cases, a customer may even stop payment to prevent the recipient from cashing a check. For example, if you write a check to pay for The New Yorker Collection 1998 Michael Maslin from cartoonbank.com. All Rights Reserved.

5 MONEY MARKET INVESTMENTS 163 home repairs, but the job is not completed, you may decide to stop payment on the check. Normally, a fee is charged for a stop payment service. Fees. Depository institutions may charge a monthly fee such as $15 per month for providing checking services unless the depositor maintains a minimum balance in the checking account or a minimum aggregate balance in other accounts at that institution. Some financial institutions charge a fee per check written instead of a monthly fee. The specific fee structure and the rules for waiving the fee vary among financial institutions, so you should compare fees before you decide where to set up your checking account. No Interest. A disadvantage of investing funds in a checking account is that the funds do not earn any interest. For this reason, you should keep only enough funds in your checking account to cover anticipated expenses and a small excess amount in case unanticipated expenses arise. You should not deposit more funds in your checking account than you think you may need, because you can earn interest by investing in other money market investments. NOW (negotiable order of withdrawal) account A type of deposit offered by depository institutions that provides checking services and pays interest. NOW ACCOUNT Another deposit offered by depository institutions is a negotiable order of withdrawal (NOW) account. An advantage of a NOW account over a traditional checking account is that it pays interest, although the interest is relatively low compared with many other bank deposits. The depositor is required to maintain a minimum balance in a NOW account, so the account is not as liquid as a traditional checking account. EXAMPLE Stephanie Spratt has a checking account with no minimum balance; she is considering opening a NOW account that requires a minimum balance of $500 and offers an interest rate of 3 percent. She has an extra $800 in her checking account that she could transfer to the NOW account. How much interest would she earn over one year in the NOW account? Interest Earned Deposit Amount Interest Rate $ $24. Stephanie would earn $24 in annual interest from the NOW account, versus zero interest from her traditional checking account. She would need to maintain the $500 minimum balance in the NOW account, whereas she has the use of all of the funds in her checking account. She decides to leave the funds in the checking account, as the extra liquidity is worth more to her than the $24 she could earn from the NOW account.

6 164 M A N A G I N G Y O U R M O N E Y EXAMPLE SAVINGS DEPOSIT Traditional savings accounts offered by a depository institution pay a higher interest rate on deposits than that offered on a NOW account. In addition, funds can normally be withdrawn from a savings account at any time. A savings account does not provide checking services. It is less liquid than a checking account or a NOW account because you have to go to the institution or to an ATM to access funds, which is less convenient than writing a check. The interest rate offered on savings deposits varies among depository institutions. Many institutions quote their rates on their Web sites. Stephanie Spratt wants to determine the amount of interest that she would earn over one year if she deposits $1,000 in a savings account that pays 4 percent interest. Interest Earned Deposit Amount Interest Rate $1, $40. Although the interest income is attractive, she cannot write checks on a savings account. As she expects to need the funds in her checking account to pay bills in the near future, she decides not to switch those funds to a savings account at this time. retail CDs Certificates of deposit that have small denominations (such as $10,000 or less). CERTIFICATE OF DEPOSIT As mentioned in Chapter 5, a certificate of deposit (CD) offered by a depository institution specifies a minimum amount that must be invested, a maturity date on which the deposit matures, and an annualized interest rate. Common maturity dates of CDs are one month, three months, six months, one year, three years, and five years. CDs can be purchased by both firms and individuals. CDs that have small denominations (such as $10,000 or less) are sometimes referred to as retail CDs because they are more attractive to individuals than to firms. Return. Depository institutions offer higher interest rates on CDs than on savings deposits. The higher return is compensation for being willing to maintain the investment until maturity. Interest rates are quoted on an annualized (yearly) basis. The interest to be generated by your investment in a CD is based on the annualized interest rate and the amount of time until maturity. The interest rates offered on CDs vary among depository institutions. EXAMPLE A three-month (90-day) CD offers an annualized interest rate of 6 percent and requires a $5,000 minimum deposit. You want to determine the amount of interest you would earn if you invested $5,000 in the CD. Since the interest rate is annualized, you will receive only a fraction of the 6 percent rate because your investment is for a fraction of the year:

7 MONEY MARKET INVESTMENTS 165 Interest Earned Deposit Amount Interest Rate Adjustment for Investment Period $5, /365 This process can be more easily understood by noting that the interest rate is applied for only 90 days, whereas the annual interest rate reflects 365 days. The interest rate that applies to your 90-day investment is for about one-fourth (90/365) of the year, so the applicable interest rate is: Interest Rate.06 90/ or 1.48%. The 1.48 percent represents the actual return on your investment. Now the interest can be determined by simply applying this return to the deposit amount: Interest Earned Deposit Amount Interest Rate $5, $ Liquidity. A penalty is imposed for early withdrawal from CDs, so these deposits are less liquid than funds deposited in a savings account. You should consider a CD only if you are certain that you will not need the funds until after it matures. You may decide to invest some of your funds in a CD and other funds in more liquid assets. Choice among CD Maturities. CDs with longer terms to maturity typically offer higher annualized interest rates. However, CDs with longer maturities tie up your funds for a longer period of time and are therefore less liquid. Your choice of a maturity for a CD may depend on your need for liquidity. For example, if you know that you may need your funds in four months, you could invest in a three-month CD and then place the funds in a more liquid asset (such as your checking account or savings account) when the CD matures. If you do not expect to need the funds for one year, you may consider a one-year CD. FOCUS ON ETHICS: RISKY DEPOSIT RATES Consider the case of a financial institution that promises an annual rate of interest to depositors that is 4 percent higher than the certificate of deposit rates offered by local banks. While this certificate sounds appealing, it is probably much riskier than you think. A firm is not going to offer an interest rate of 4 percent more than other interest-bearing investments unless it needs to pay such a high return in order to compensate for risk. Inquire if the deposit is insured by the FDIC. While you might possibly earn 4 percent more on this investment than by depositing the funds at a bank, you might also lose 100 percent of your money if the financial institution goes bankrupt. There are many investment companies that prey on

8 166 M A N A G I N G Y O U R M O N E Y individuals (especially the elderly) who presume that because an investment sounds like a bank deposit, it is insured and safe. If an investment sounds too good to be true, it probably is. money market deposit account (MMDA) A deposit offered by a depository institution that requires a minimum balance, has no maturity date, pays interest, and allows a limited number of checks to be written each month. Treasury securities Debt securities issued by the U.S. Treasury. Treasury bills (T-bills) Treasury securities with maturities of one year or less. MONEY MARKET DEPOSIT ACCOUNT (MMDA) A money market deposit account (MMDA) is a deposit account offered by a depository institution that requires a minimum balance to be maintained, has no maturity date, pays interest, and allows a limited number of checks to be written each month. The specific details vary among financial institutions. For example, an account might require that a minimum balance of $2,500 be maintained over the month and charge a $15 per month fee in any month when the minimum balance falls below that level. An MMDA differs from a NOW account in that it provides only limited checking services while paying a higher interest rate than that offered on NOW accounts. Many individuals maintain a checking account or NOW account to cover most of their day-to-day transactions and an MMDA to capitalize on the higher interest rate. Thus, they may maintain a larger amount of funds in the MMDA and use this account to write a large check for an unexpected expense. The MMDA is not as liquid as a checking account because it limits the amount of checks that can be written. TREASURY BILLS As mentioned in Chapter 5, Treasury securities are debt securities issued by the U.S. Treasury. When the U.S. government needs to spend more money than it has received in taxes, it borrows funds by issuing Treasury securities. Individuals can purchase Treasury securities through a brokerage firm. Treasury securities are offered with various maturities, such as three months, six months, one year, 10 years, and 30 years. For money management purposes, individuals tend to focus on Treasury bills (T-bills), which are Treasury securities that will mature in one year or less. T-bills are available with a minimum value at maturity (called the par value) of $10,000 and are denominated in multiples of $5,000 above that minimum. Return. Treasury bills are purchased at a discount from par value. If you invest in a T-bill and hold it until maturity, you earn a capital gain, which is the difference between the par value of the T-bill at maturity and the amount you paid for the T-bill. Your return on the T-bill is the capital gain as a percentage of your initial investment. EXAMPLE An investor pays $9,400 to purchase a T-bill that has a par value of $10,000 and a one-year maturity. When the T-bill matures, she receives $10,000. The return from investing in the T-bill is: Return on T-Bill $10,000 $9,400 $9, %.

9 MONEY MARKET INVESTMENTS Financial Planning Online: Deposit Rates Offered by Banks Go to: /brm/rate/dep_home.asp This Web site provides: information on the highest interest rates offered on deposits by banks across the United States as well as in your specific city. EXAMPLE When measuring returns on investments, you should annualize the returns so that you can compare returns on various investments with different maturities. An investment over a one-month period will likely generate a smaller dollar amount of return than a one-year investment. To compare the one-month and one-year investments, you need to determine the annualized yield (or percentage return) on each investment. For an investment that lasts three months (one-fourth of a year), multiply by 4 to determine the annualized return. For an investment that lasts six months (one-half of a year), multiply by 2 to determine the annualized return. The most precise method of annualizing a return is to multiply the return by 365/N, where N is the number of days the investment existed. An investor pays $9,700 to purchase a T-bill with a par value of $10,000 and a maturity of 182 days. The annualized return from investing in the T-bill is: Return on T-Bill $10,000 $9, $9, %. secondary market A market where existing securities such as Treasury bills can be purchased or sold. Secondary Market. There is a secondary market for T-bills where they can be sold before their maturity with the help of a brokerage firm. This secondary market also allows individuals to purchase T-bills that were previously owned

10 168 M A N A G I N G Y O U R M O N E Y EXAMPLE by someone else. The return on a T-bill is usually slightly lower than the return on a CD with the same maturity, but T-bills are more liquid because they have a secondary market, whereas CDs must be held until maturity. If you sell a T- bill in the secondary market, your capital gain is the difference between what you sold the T-bill for and what you paid for the T-bill. Your return is this capital gain as a percentage of your initial investment. An investor purchases a T-bill for $9,700 and sells the T-bill in the secondary market 60 days later for a price of $9,820. The annualized return is: Return on T-Bill $9,820 $9, $9, %. Quotations. The prices of various T-bills and the returns they offer for holding them until maturity are quoted in financial newspapers and online. money market funds (MMFs) Accounts that pool money from individuals and invest in securities that have a short-term maturity, such as one year or less. commercial paper Short-term debt securities issued by large corporations that typically offer a slightly higher return than Treasury bills. MONEY MARKET FUNDS (MMFS) Money market funds (MMFs) pool money from individuals to invest in securities that have a short-term maturity, such as one year or less. In fact, the average time remaining to maturity of debt securities held in an MMF is typically less than 90 days. Many MMFs invest in short-term Treasury securities or in wholesale CDs (in denominations of $100,000 or more). Investors can invest in MMFs by sending a check for the amount they wish to have invested for them. Some MMFs invest mainly in commercial paper, which consists of short-term debt securities issued by large corporations. Commercial paper typically generates a slightly higher interest rate than T-bills. Money market funds are not insured, but most of them invest in very safe investments and have a very low risk of default. MMFs offer some liquidity in that individuals can write a limited number of checks on their accounts each month. Often the checks must exceed a minimum amount (such as $250). Individuals may use the checking account associated with an MMF to cover large expenditures, while maintaining a regular checking account to cover smaller purchases. Many individuals invest in an MMF so that they can earn interest until the money is needed. Some MMFs are linked with other accounts so that the money can earn interest until it is transferred to another account. For example, many brokerage accounts allow investors to place any unused funds in an MMF until the funds are used to purchase stock. EXAMPLE Assume that you set up an account with $9,000 to purchase stock at a brokerage firm on May 1. On that day, you purchase 100 shares of a stock priced at $50. To

11 MONEY MARKET INVESTMENTS 169 cover the purchase, the brokerage firm withdraws $5,000 (computed as $ shares) from your account. You still have $4,000 that you have not used, which is placed in a specific MMF account at the brokerage firm. This MMF offers the same limited check-writing services as other MMFs. The money will sit in that account until you use it to purchase stock or write checks against the account. Assuming that the interest rate earned on the MMF is 6 percent annually (.5 percent per month), and you do not purchase any more stock until June 1, you will earn interest on that account over the month when the funds were not used: Amount Invested in MMF Interest Rate per Month Interest Earned in 1 Month $4, $20. Therefore, the MMF account balance increases by $20 to $4,020 because the funds earned interest. Any unused balance will continue to earn interest until you use it to purchase stock or write checks against the account. Money Market Fund Quotations. Every Thursday the Wall Street Journal publishes the yields provided by various money market funds, as shown in Exhibit 6.1. The first column lists the name of the MMF; the second column, the average maturity of the investments of that fund; the third column, the annualized yield generated by the fund; and the fourth column, the size of the fund (measured in millions of dollars). As an example, the Janus fund that invests in government securities is highlighted in Exhibit 6.1. This fund s investments have an average time to maturity of 36 days. The fund generated Exhibit 6.1 Weekly Money Market Fund Yields Copyright 2003 Dow Jones & Company, Inc. All Rights Reserved.

12 170 M A N A G I N G Y O U R M O N E Y an annualized yield of.89 percent to its investors over the last 7 days. It has $427 million in assets. asset management account An account that combines deposit accounts with a brokerage account and provides a single consolidated statement. ASSET MANAGEMENT ACCOUNT An asset management account combines deposit accounts with a brokerage account that is used to buy or sell stocks. The advantage of an asset management account is that it provides a single consolidated statement showing the ending balances and activity of all the accounts. Asset management accounts are available at some depository institutions and brokerage services. The financial institutions that offer these accounts require that the sum of all the accounts in the asset management account exceed some minimum amount, such as $15,000. One of the special benefits that may be offered to individuals who maintain an asset management account is a so-called sweep account that sweeps any unused balance in the checking account into the money market account at the end of the day. Any unused balance remains available for writing checks and earns interest in the meantime. COMPARISON OF MONEY MARKET INVESTMENTS The various money market investments are compared in Exhibit 6.2. Notice that money market investments that offer a higher return tend to have less liquidity. The relationship between the returns and the liquidity of money market investments is illustrated graphically in Exhibit 6.3. Checking accounts offer the most liquidity but provide no return. At the other extreme, a one-year CD provides the highest return but has less liquidity than the other money market instruments. Exhibit 6.2 Comparison of Money Market Investments Money Market Investment Advantages Disadvantages Checking account Very liquid No interest NOW account Very liquid Low interest rate; minimum balance required MMDA Liquid Low interest rate Savings account Liquid Low interest rate Certificate of deposit (CD) Relatively high interest rate Less liquid Treasury bill Relatively high interest rate High minimum purchase Money market fund (MMF) Liquid Not as liquid as checking or NOW accounts Asset management account Convenient High minimum balance required

13 RISK OF MONEY MARKET INVESTMENTS 171 Exhibit 6.3 Return Comparison of the Liquidity and Returns of Money Market Instruments One-Year CD Three-Month CD Three-Month T-bill Savings Account MMDA NOW Account Checking Account Liquidity RISK OF MONEY MARKET INVESTMENTS Before you consider investing short-term funds in various money market instruments, you must factor in your exposure to risk, or the uncertainty surrounding the potential return. Money market investments are vulnerable to three types of risk: (1) credit risk, (2) interest rate risk, and (3) liquidity risk. 6.2 Financial Planning Online: Impact of Different Deposit Rates on Your Wealth Go to: tools/savingscalc/ savingscalc.html This Web site provides: Estimates of future savings that you will accumulate over time at different interest rates in taxable or nontaxable accounts adjusted for inflation.

14 172 M A N A G I N G Y O U R M O N E Y 6.3 Financial Planning Online: Identifying Insured Investments Go to: consumer_information/ what_you_should_know_ about_internet_banking.cfm Click on: Banking Consumers Option This Web site provides: a comparison of the different methods of investing your money in a bank and identifies the investments that are backed by the U.S. government. credit risk (or default risk) The risk that a borrower may not repay on a timely basis. interest rate risk The risk that the value of an investment could decline as a result of a change in interest rates. CREDIT RISK When you invest in money market securities, you may be exposed to credit risk (also referred to as default risk), which is the risk that the borrower will not repay on a timely basis. The borrower may make late payments or may even default on the credit; in that event, you will receive only a portion (or none) of the money you invested. MMFs that invest in large deposits of financial institutions that are insured only up to $100,000 and in short-term securities issued by firms are exposed to credit risk. Other money market investments are insulated from credit risk. For example, deposits at commercial banks and savings institutions are insured up to $100,000 by the Federal Deposit Insurance Corporation (FDIC). Treasury securities are backed by the federal government. INTEREST RATE RISK Interest rate risk is the risk that the value of an investment could decline as a result of a change in interest rates. EXAMPLE Suppose that you purchase a one-year T-bill that offers you a return of 5 percent over the next year. Three months after you purchase the Treasury security, interest rates rise. Now you are disappointed that you locked in this investment at 5 percent

15 RISK MANAGEMENT OF MONEY MARKET INVESTMENTS 173 because other investments (including existing T-bills) are now offering an annualized return of about 6 percent for investors who hold the security until maturity. You can sell your T-bill in the secondary market, but you realize that investors will pay a relatively low price for it because they can buy new securities that offer an annualized return of 6 percent. This explains why the value of a debt security decreases in response to an increase in interest rates. If you do not want to sell your T-bill for a discounted price, you can simply hold on to it until it matures. However, the return on your investment over the entire one-year period will be only 5 percent even though T-bills issued after you purchased your security are offering higher returns. Neither of your two options is desirable. Investors who wish to limit their exposure to interest rate risk can invest in debt securities that have shorter maturities. If you had held a three-month security instead of a one-year security in the previous example, you could have redeemed your security at maturity after three months and reinvested your money at the prevailing higher interest rate. liquidity risk The potential loss that could occur as a result of converting an investment into cash. LIQUIDITY RISK Recall that liquidity represents your ability to cover any short-term cash deficiencies. To be liquid, an investment should be easily converted to cash. Liquidity risk is the potential loss that could occur as a result of converting an investment to cash. For example, a retail CD has liquidity risk because it cannot be sold in the secondary market. You would suffer a penalty if you tried to redeem it before maturity at the financial institution where you invested in the CD. The liquidity risk of an investment is influenced by its secondary market. If a particular debt security has a strong secondary market, it can usually be sold quickly and at less of a discount than a debt security with an inactive secondary market. For example, you can easily sell a T-bill in a secondary market, which is why T-bills are more liquid than CDs. RISK MANAGEMENT OF MONEY MARKET INVESTMENTS Risk management of money market investments involves (1) assessing the risk exhibited by the investments and (2) using your assessment of risk and your unique financial situation to determine the optimal allocation of your shortterm funds among money market investments. RISK ASSESSMENT OF MONEY MARKET INVESTMENTS You must consider the risk-return tradeoff before making investment decisions. The money market securities described in this chapter tend to be insulated from credit risk because they are insured or backed by the government. Treasury securities and small bank deposits are largely free from credit risk. One exception is MMFs that invest in commercial paper. If the commercial paper held by

16 174 M A N A G I N G Y O U R M O N E Y a particular MMF defaults, the return generated by the MMF will be adversely affected, and so will the return to investors who invested in that MMF. As mentioned earlier, money market investments that have shorter maturities have less interest rate risk. In addition, investments in MMFs tend to have the least liquidity risk, especially when their investments focus on securities that will mature within the next month. Treasury securities that will mature in the next month or so also have very little liquidity risk. Would you invest in a high-risk security if a lower-risk security offered the same yield? Probably not. Securities that are exposed to risk have to offer higher yields than less risky investments to attract funds from investors. The prospect of a higher return compensates investors for taking on a higher level of risk. Investors can earn a higher return by investing in MMFs that hold investments subject to credit risk and for securities that are particularly vulnerable to interest rate risk. Recall that debt securities with shorter maturities offer lower annualized yields. A three-month debt security typically offers a slightly lower annualized yield than a one-year security. However, the debt securities with longer maturities have more exposure to interest rate risk. Yields are also higher for securities that are more exposed to liquidity risk. A retail CD must offer a slightly higher yield than a Treasury security with the same maturity because the Treasury security is more liquid. DETERMINING THE OPTIMAL ALLOCATION OF MONEY MARKET INVESTMENTS In general, your money management should be guided by the following steps: 1. Anticipate your upcoming bills, and ensure that you have sufficient funds in your checking account. 2. Estimate the additional funds that you might need in the near future, and consider investing them in an investment that offers sufficient liquidity (such as an MMF). You may even keep a little extra in reserve here for unanticipated expenses. 3. Use the remaining funds in a manner that will earn you a higher return, within your level of risk tolerance. The optimal allocation for you will likely be different from the optimal allocation for another individual. If your future net cash flows will be far short of upcoming expenses, you will need to keep a relatively large proportion of funds in a liquid investment (such as a checking account or a NOW account). Another person who has sufficient cash flows to cover expenses will not need much liquidity. The difference is illustrated in Exhibit 6.4. Even though the two individuals have the same level of net cash flows, one person must maintain more liquidity than the other. Your decision on how to invest your short-term funds (after determining how much money to maintain in your checking account) should account for your willingness to tolerate risk. If you want to minimize all forms of risk, you may simply consider investing all of your funds in an MMF that always focuses on Treasury securities maturing within a month or less. However, you will likely

17 RISK MANAGEMENT OF MONEY MARKET INVESTMENTS 175 Exhibit 6.4 How Liquidity Is Affected by Anticipated Expenses Net Cash Flows Allocate to Nonliquid Funds Allocate to Liquid Funds Long-Term Investments Cover Anticipated Expenses Net Cash Flows Allocate to Nonliquid Funds Allocate to Liquid Funds Long-Term Investments Cover Anticipated Expenses improve on the yield if you are willing to accept some degree of risk. For example, if you know that you will not need your funds for at least six months and do not expect interest rates to rise substantially over that period, you might consider investing your funds in a six-month retail CD. A compromise would be to invest a portion of your short-term funds in the six-month retail CD and the remaining funds in the MMF that focuses on Treasury securities. The CD offers you a higher expected return (although less liquidity), while the MMF offers you liquidity in case you need funds immediately. EXAMPLE Stephanie Spratt has $2,000 available to allocate to money market investments. She knows that she will need $400 to cover several small bills in the next week and may also need $600 in a month or so to pay for repairs on her car engine. She does not expect to need the other funds for at least six months. Her financial institution offers the following annualized yields on various money market instruments: Annualized Yield (%) Checking account 0 NOW account ($500 minimum balance) 2.0 Savings deposit 3.0 MMDA ($2,500 minimum balance) 4.0 MMF ($300 minimum balance) 4.0 Three-month CD 4.5 Six-month CD 5.2 One-year CD 6.0

18 176 M A N A G I N G Y O U R M O N E Y Stephanie s existing checking account has a balance close to zero. She also has an MMF with a balance of $300, which she must maintain to meet the minimum balance. She will first focus on meeting her liquidity needs and then decide how to invest the remaining funds that are not needed to cover possible expenses. She decides to allocate $400 to her checking account so that she can write several checks to cover her upcoming bills. It is not worthwhile to invest these funds elsewhere as she will need the funds soon, and the checking account is the only investment that will allow her to write several small checks. She knows that she might need another $600 in the near future for car repairs, but wants to earn as high a return as possible until she needs the money. She immediately eliminates the MMDA from consideration because it would require a minimum balance of $2,500. She decides to invest the $600 in her MMF. She can write a check from this account to cover the car repairs; meanwhile, the funds invested in the MMF will earn 4 percent interest on an annualized basis. Stephanie now has $1,000 remaining to allocate and anticipates that she will not need the money for at least six months. She does not consider investing the $1,000 in a one-year CD, even though it offers a relatively high interest rate, because she may need the funds in six months. She decides to invest the $1,000 in a six-month CD, so that she can increase liquidity while still earning a relatively high return. If Stephanie had excess funds that she would not need for a few years, she would consider investing the residual in other investments (such as stocks) that offer a higher potential return. The potential return and risk of these other investments are discussed in Part 5. HOW MONEY MANAGEMENT FITS WITHIN YOUR FINANCIAL PLAN The following are the key money management decisions that you should include in your financial plan: 1. How can you ensure that you can pay your anticipated bills on time? 2. How can you maintain adequate liquidity in case you incur unanticipated expenses? 3. How should you invest any remaining funds among money market investments? By making proper decisions, you can minimize your use of credit and can maximize the return on your liquid assets. As an example, Exhibit 6.5 shows how money market decisions apply to Stephanie Spratt s financial plan.

19 DISCUSSION QUESTIONS 177 Exhibit 6.5 How Money Management Fits within Stephanie Spratt s Financial Plan Goals for Money Management 1. Maintain sufficient liquidity to ensure that all anticipated bills are paid on time. 2. Maintain sufficient liquidity in case I incur unanticipated expenses. 3. Invest any excess funds in deposits that offer the highest return while ensuring adequate liquidity. Analysis Amount Payment Method Monthly cash inflows $2,500 Direct deposited into checking account. Typical monthly expenses 1,400 Write checks to pay these bills. Other expenses for clothing or recreation 700 Use credit cards and then pay the credit card balance by check once a month. Decisions Decision on How to Ensure Adequate Liquidity to Cover Anticipated Expenses: The two paychecks I receive each month amounting to $2,500 after taxes are direct deposited into my checking account. I can use this account to cover the $1,400 in anticipated bills each month. I can also use this account to write a check for the monthly credit card bill. I will attempt to leave about $400 extra in the checking account because my expenses may vary from month to month. Decision on How to Ensure Liquidity to Cover Unanticipated Expenses: I will also attempt to maintain about $2,500 in a money market fund or a money market deposit account in case I need additional funds. I can earn interest on this money while ensuring liquidity. Decision on How to Invest Remaining Funds so as to Achieve the Highest Return While Enhancing Liquidity: As I accumulate additional savings, I will invest in certificates of deposit with short terms to maturity (such as one month). This money will not be as liquid as the MMF or MMDA, but it will be accessible when the CD matures. The interest rate on the CD will be higher than the interest I can earn on my MMF or MMDA. DISCUSSION QUESTIONS 1. How would Stephanie s money management decisions be different if she were a single mother of two children? 2. How would Stephanie s money management decisions be affected if she were 35 years old? If she were 50 years old?

20 178 M A N A G I N G Y O U R M O N E Y SUMMARY Money management involves the selection of shortterm investments that satisfy your liquidity needs and also provide you with an adequate return on your investment. It is challenging because the shortterm investments that offer relatively high returns tend to have less liquidity. Popular short-term investments considered for money management include checking accounts, NOW accounts, savings accounts, CDs, MMDAs, Treasury bills, money market funds, and asset management accounts. Checking accounts and NOW accounts offer the most liquidity. CDs and T-bills offer the highest return. The risks related to money market investments are credit (default) risk, interest rate risk, and liquidity risk. The money market investments offered by depository institutions are insured and insulate you from the risk that the institution could default. Investments in T-bills have no default risk because they are backed by the federal government. Money market securities tend to have a low level of interest rate risk because they have short-term maturities. They also have relatively low liquidity risk because of the short-term maturities of their assets. When applying money management, you should first anticipate your expenses in the next month and maintain enough funds in your checking account to cover those expenses. In addition, you should estimate the potential level of unanticipated expenses (such as possible car repairs) and maintain enough funds in a short-term investment such as a money market fund to cover these expenses. Finally, invest the remaining funds to earn a high return within your level of risk tolerance. INTEGRATING THE KEY CONCEPTS Your money management decisions determine your level of liquidity and also affect other parts of your financial plan. If your money market investments have a high degree of liquidity, you have more funds that you can use. The amount of liquidity that you maintain is partly determined by your budgeting decisions (Part 1) because you will need more liquidity if your cash outflows are expected to exceed your cash inflows. The decision to maintain a high degree of liquidity can affect your financing decisions (Part 3) because the more of your cash that you can use, the less you will need to rely on loans. Your money management will also affect your investment decisions (Part 5) because you can focus on investments that are not liquid if you already have sufficient liquidity from your money market investments. 6. Retirement and Estate Planning (Retirement Planning, Estate Planning) 5. Investing (Stocks, Bonds, Mutual Funds) 1. Financial Planning Tools (Budgeting, Time Value, Tax Planning) Your Money Management Decisions 4. Protecting Your Assets and Income (Insurance) 2. Liquidity Management (Banking, Money Management, Credit Management) 3. Financing (Personal Loans, Mortgages)

21 FINANCIAL PLANNING PROBLEMS 179 REVIEW QUESTIONS 1. Define money management. How does it differ from long-term investment or long-term borrowing decisions? 2. What is liquidity? How is your personal cash flow statement used to help manage your liquidity? How does money management relate to the cash flow statement? 3. Name some ways an individual might handle a cash flow deficiency. Which way would be preferable? Why? 4. What is the opportunity cost of having excessive amounts of liquid funds? 5. What two factors affect the return on short-term investments? What investments should you consider to achieve liquidity and an adequate return? 6. Why do individuals use checking accounts? What is the disadvantage of having funds in a checking account? Explain overdraft protection and stop payment orders. Are all bank fee structures the same? 7. What is a NOW account? How is it different from a regular checking account? How does a savings account compare with a NOW account? 8. What terms does a financial institution specify for certificates of deposit? Why are rates on CDs higher than those on savings accounts? What factor would most affect your choice of maturity date on a CD? 9. How does a money market deposit account (MMDA) differ from a NOW account? When might a depositor use an MMDA? 10. What are Treasury securities? What is a T-bill? How is it denominated? How do you earn a return on a T-bill? How is the return calculated? 11. Compare the interest rates offered on T-bills and CDs. Which type of investment is more liquid? Why? 12. What are money market funds (MMFs)? What types of securities do they invest in? What is commercial paper? Are MMFs risky investments? Are MMFs liquid? 13. What is an asset management account? Discuss the advantages of such an account as well as its requirements. 14. Compare the return and liquidity of the various money market investments. Give specific examples. 15. What are the three types of risk money market investments are vulnerable to? 16. Generally compare the money market investments described in this chapter in terms of their vulnerability to credit risk, interest rate risk, and liquidity risk. Provide some examples of specific securities. What is the risk-return tradeoff for these investments? 17. What steps should you take to determine the best allocation of your money market investments? What factors should you consider in determining your allocation? FINANCIAL PLANNING PROBLEMS 1. Teresa has just opened a NOW account that pays 3.5 percent interest. If she maintains a minimum balance of $500 for the next 12 months, how much interest will she earn? 2. Nancy is depositing $2,500 in a six-month CD that pays 4.25 percent interest. How much interest will she accrue if she holds the CD until maturity? 3. Travis has invested $3,000 in a three-month CD at 4 percent. How much will Travis have when the CD matures? 4. Teddy has invested $10,000 in an 18-month CD that pays 6.25 percent. How much interest will Teddy receive at maturity? 5. Troy paid $9,600 for a T-bill with a face value of $10,000. What is Troy s return if he holds the T-bill to maturity? 6. Bart is a college student who has never invested his funds. He has saved $1,000 and has decided to invest the funds in a money market fund with an expected return of 2.0 percent. Bart will need the funds in one year. Brokerage commissions will cost Bart $20 at the time he withdraws the funds in one year. How much money will Bart have in one year as a result of this investment? 7. Davis has $20,000 excess cash to invest. He can purchase a $20,000 T-bill for $19,400 or two $10,000 T-bills for $9,600 each. Which will give him the better return?

22 180 M A N A G I N G Y O U R M O N E Y 8. Stacy purchased a $40,000 T-bill for $38,400. A few months later, Stacy sold the T-bill for $39,000. What was Stacy s return on the T-bill? 9. Brenda purchased a $30,000, 90-day T-bill for $29,550. What will Brenda s return be when the T-bill matures? What will her annualized rate be? 10. On June 1, Amy deposited $4,000 in a MMDA that pays 5 percent interest. On October 31, Amy invested $2,000 in a three-month CD that pays 6 percent. At the end of the year, how much interest will Amy have earned, assuming she hasn t taken anything out of the money market deposit account? 11. Thomas can invest $10,000 by purchasing a 1- year T-bill for $9,275, or he can place the $10,000 in a 12-month CD paying 8 percent. Which investment will provide the higher return? In addition to return, what else should Thomas consider when making his investment decision? FINANCIAL PLANNING ONLINE EXERCISES 1. Go to SAV2.cgi/FinanCenter. Using this site, you can find the answer to the question, How Much Will My Savings Be Worth? a. By inputting an investment amount, the monthly deposit, the return, the period of investment, the tax rate, and the inflation rate, you can calculate the value of your investment. Input $5,000 as the initial investment, $100 for the monthly deposit, 6 percent for the return, 25 percent for the federal tax rate, 6 percent for the state tax rate, 3 percent for the inflation rate. How much will your investment be worth in 20 years? Click on the Graphs option to view the results graphically. b. Now change the monthly deposit to $300. How much will your investment be worth in 20 years? c. Now change the period of investment to 30 years. How much more money will you be able to accumulate in 30 years as opposed to 20, using the original $100 monthly deposit amount? d. Now change the rate you can earn on your investment from 6 to 8 percent and evaluate the results and graph using the original inputs. 2. Go to SAV2.cgi/FinanCenter. a. Determine how much you need to save for a major purchase. Input $8,000 as the amount you need, $1,000 as what you will invest now, a $100 monthly deposit, 36 months for the savings period, 6 percent return, 25 percent federal tax rate, and 6 percent state tax rate. Will your investing plan allow you to achieve your goal? If not, how should you revise your plan? Click on Graphs to view the results graphically. b. To accumulate $15,000 for a down payment on a house, you plan to save $150 per month over a five-year period at an 8 percent return. Will your plan work? If not, how should you revise it? Assume the same tax rates as in part a. c. So, you want to be a millionaire. Can you accumulate $1 million to use for your retirement with an initial investment of $25,000, monthly investments of $750, and a 7 percent return over a 30-year period? If not, what adjustments can you make? Assume the same tax rates as in part a. BUILDING YOUR OWN FINANCIAL PLAN Money market investments provide vehicles to assist you in accomplishing your short-term financial goals. Refer back to the three to five short-term goals you established in Chapter 1. For each goal, rate the importance (high, medium, or low) of the following items: 1. Liquidity 2. Risk 3. Fees/minimum balance 4. Return

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