Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Personal Finance SIXTH EDITION Chapter 6 Managing Your Money

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Chapter Objective 6.1 Provide a background on money management 6.2 Describe the most popular money market investments 6.3 Identify the risk associated with money market investments 6.4 Explain how to manage the risk of your money market investments 6.5 Explain how money management fits within your financial plan

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Background on Money Management (1 of 2) Money management: a series of decisions made over a short-term period regarding cash inflows and outflows Liquidity: your ability to cover any cash deficiencies that you may experience –Related to your personal cash flow statement

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Background on Money Management (2 of 2) –Using credit cards for liquidity  Interest rate usually high  Maintaining adequate liquid assets allows you to avoid using credit cards and paying high finance charges –Adequate return  Try to achieve highest possible returns on short-term investments

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (1 of 11) Checking Account –Very liquid investment –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  Saves overdraft fees and bounced checks  Results in high interest rate on borrowed amount

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (2 of 11) –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 –Direct deposit – paychecks go directly to your financial institution –Fees – vary from institution to institution –No interest on most checking accounts

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (3 of 11) NOW (negotiable order of withdrawal) account: a type of deposit offered by depository institutions that provides checking services and pays interest –Requires a minimum balance, lowering liquidity Savings deposits pay interest and are slightly less liquid than checking accounts –Automatic transfer feature can help saving

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (4 of 11) Certificate of Deposit –Retail CDs: certificates of deposit that have small denominations –Return—CDs pay higher interest rates than savings deposits –Liquidity—penalties are imposed for early withdrawal –Choice among CD maturities

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (5 of 11) 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 –Less liquid than checking, but pays a higher interest rate –Many people keep a checking or NOW account for day-to-day and a money market for other funds

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (6 of 11) Treasury securities: debt securities issued by the U.S. Treasury Treasury bills (T-bills): Treasury securities with maturities of one year or less –Return—purchased at a discount; result in capital gains –Secondary market: a market where existing securities such as Treasury bills can be purchased or sold –Quotations – prices online and in financial news publications

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (7 of 11) Money Market Funds (MMFs): accounts that pool money from individuals and invest in securities that have a short-term maturity –Typically less than 90 days –Commercial paper: short-term debt securities issued by large corporations that typically offer a slightly higher return than Treasury bills – Money market fund quotations  Found in financial newspapers and online

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (8 of 11) EXHIBIT 6.1 Weekly Money Market Fund Yields FundAverage Maturity7-Day YieldAssets (millions of $) Star Fund433.28%496

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (1 of 3) Go to the data section of This Web site provides historical interest rate data

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (9 of 11) Asset Management Account: an account that combines deposit accounts with a brokerage account and provides a single consolidated statement –Sweep account: an asset management account that sweeps any unused balance in the brokerage account into a money market investment at the end of each business day

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (10 of 11) EXHIBIT 6.2 Comparison of Money Market Investments Money Market InvestmentAdvantagesDisadvantages Checking accountVery liquidNo interest NOW accountVery liquidLow interest rate; minimum balance required MMDALiquidLow interest rate Savings accountLiquidLow interest rate Certificate of deposit (CD)Relatively high interest rateLess liquid Treasury billRelatively high interest rateHigh minimum purchase Money market fund (MMF)LiquidNot as liquid as checking or NOW accounts Asset management accountConvenientHigh minimum balance required

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Money Market Investments (11 of 11)

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Risk of Money Market Investments (1 of 3) 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 Liquidity risk: the potential loss that could occur as a result of converting an investment into cash

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (2 of 3) Go to the money section of CNN.com and go to the personal finance section containing calculators This site provides estimates of future savings that you can accumulate over time with different interest rates in taxable or nontaxable accounts adjusted for inflation.

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Risk of Money Market Investments (2 of 3) Impact of expected economic conditions on liquidity needs –Weak economic conditions can create liquidity problems  Job loss  Fewer hours worked  Poor returns on investments –This could be a time to allocate more funds to liquid investments

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Risk of Money Market Investments (3 of 3)

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Risk Management (1 of 3) Always consider the risk-return tradeoff before making investment decisions Most money market instruments are largely free from credit risk Money Market Funds (MMFs) do carry some credit risk since they may hold commercial paper

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Risk Management (2 of 3) Determining the optimal allocation of money market investments −Anticipate upcoming bills and have adequate funds in your checking account −Estimate additional funds needed in near future and invest in a liquid investment −Use remaining funds in a way that will maximize your return, considering your risk tolerance

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Risk Management (3 of 3) Recently, interest rates on money market investments have been low –Resist temptation of reduce these investments in favor of stocks –Money market investments have a specific purpose – to provide easy access to funds

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Financial Planning Online (3 of 3) Go to This Web site provides information on what types of investments are insured and what types are not.

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved Optimal Allocation of Money Market Investments

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How Money Management Fits Within Your Financial Plan (1 of 4) Key money management decisions for your financial plan are: –How can you ensure that you can pay your anticipated bills on time? –How can you maintain adequate liquidity in case you incur unanticipated expenses? –How should you invest any remaining funds among money market investments?

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How Money Management Fits Within Your Financial Plan (2 of 4) EXHIBIT 6.6 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 accounts that offer the highest return while ensuring adequate liquidity. ANALYSIS AmountPayment Method Monthly cash inflows$2,500Direct deposited into checking account. Typical monthly expenses 1,400Make payments to pay these bills. Other expenses for clothing or recreation 600Use credit cards and then pay the credit card balance by check once a month.

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How Money Management Fits Within Your Financial Plan (3 of 4) EXHIBIT 6.6 How Money Management Fits Within Stephanie Spratt’s Financial Plan 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.

Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved How Money Management Fits Within Your Financial Plan (4 of 4) EXHIBIT 6.6 How Money Management Fits Within Stephanie Spratt’s Financial Plan Decision on How to Ensure Liquidity to Cover Unanticipated Expenses: The two paychecks I will also attempt to maintain about $2,500 in a money market fund (MMF) in case I need additional funds. I can earn interest on this money while ensuring liquidity. Decision on How to Invest Remaining Funds 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, 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.