Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Investments in cash and cash equivalents –Not just physical money –Includes investments in bank certificates of deposit, bank savings accounts, short-term United States Treasury issues, and money market mutual funds

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 What is it? Certificate of Deposit (CDs) –A debt instrument issued by a “bank” in exchange for a deposit made by an investor –Usually issued in minimum amounts of $5,000 –Terms can range from 7 days to ten years –Interest rates on these certificates are frequently tied to the rate paid on U.S. Treasury investments of comparable maturity range

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 What is it? Money Market Fund –A mutual fund that invests solely in short-term debt instruments. –The term “money market” is applied to high quality, short-term debt instruments that mature in one year. These include: U.S. Treasury bills Certificates of Deposit Commercial Paper Bankers Acceptances Municipal Paper Eurodollar Investments

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 What is it? U.S. Treasury bills –Short-term certificates issued by the federal government –Typically mature in three months to one year Certificates of Deposit –Includes certificates of foreign banks as well as domestic institutions –Foreign CDs pay a slightly higher rate of return because of the somewhat higher risk associated with them Commercial Paper –Short-term debt of major industrial corporations –Typically matures in 60 days to one year

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 What is it? Bankers Acceptances –Short-term (30 to 360 days) “drafts” drawn on a major bank –Typically used to finance international import/export transactions Municipal Paper –Issued by state, county, or local governments or agencies –Interest is exempt from federal income taxes and state and local income taxes depending on the investor’s residency

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 What is it? Eurodollar Investments –Time deposits denominated in U.S. dollars –Held in banks outside of the U.S. or in foreign branches of U.S. banks –Typically, the minimum investment is $1,000,000 –Trading is very active in maturities up to six months. –The term “Eurodollar” does not strictly apply to deposits held in Europe Applies on a worldwide basis

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 When is the use of this tool Indicated? When an investor desires a high degree of liquidity –The investor wants the ability to convert an investment into cash quickly with little or no cost involved. –Ideal for investors possessing large amounts of idle cash who wish to invest it for a short time period When there is a need for a high degree of safety of principal –The combination of short maturities and the high quality of the issuers of money market securities provide this desired security.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 When is the use of this tool Indicated? When an investor desires a higher rate of return than a passbook-type of account and more flexibility than longer-term investments When immediate access or availability of the funds is desired –A penalty may be imposed in the case of a premature redemption of a CD

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Advantages CDs are generally insured by the federal government up to a maximum of $100,000 per account ownership title –Mutual fund money market funds are not guaranteed by any federal agency. An investment in a money market fund can be converted easily and conveniently into cash –Almost all banks will redeem their CDs prior to maturity on demand –There are penalties for early withdrawal of funds from CDs, which can include a withdrawal penalty and a reduction in the rate of interest earned.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Advantages Shorter maturity period than bonds and common stocks Most money market funds offer shareholder personalized check writing services and the ability to wire transfer money from the fund to the investor’s bank account. Provide a secure investment –This is due to the financial strength of the issuers of the underlying assets held by money market funds. –There will be little or no fluctuation in the market value of the investment. –The return of capital is virtually assured.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Advantages The rate of return offered by money market funds is highly sensitive to changes in short-term interest rates. Most money market funds do not impose a sales charge on purchases of the fund or a redemption fee when shares are sold. –Management fees of approximately 0.2% to 0.7% of the fund are applied annually –An administrative charge may apply to accounts with balances below a certain level, such as $10,000.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Advantages CDs may be “laddered” in maturity dates to manage interest rate risk –If liquidity is needed (taking away long-term CDs as an investment option) or interest rates rise, an investment staggered into 6-month, 12-month, 18-month, 24-month, and 30-month maturities will give a higher interest rate than simply a 6-month maturity. –It also gives the opportunity to reinvest at higher rates as each 6- month CD matures and is reinvested 6 months beyond the longest maturity. Money market mutual funds are available for tax-exempt investors

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Disadvantages The rate of return on CDs is lower than rates typically available on higher risk alternatives. A substantial penalty is charged if the investor redeems the certificate prior to maturity. –This penalty can greatly reduce the overall rate of return on the investment. Money market funds do not pay as high a rate of return as longer-term investments such as bonds.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Disadvantages All of the income generated by a money market investment such as CDs will be taxed as ordinary income. –The investor has no control over the timing of income received and must report all income currently. Investments in money market funds are not insured or guaranteed by any federal agency. –Monkey market funds are relatively unregulated and do not have the federally mandated reserve requirements of banks.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 Tax Implications All of the income from CDs and money market funds is fully taxable and subject to ordinary income tax rates. –“Dividends” from a money fund are considered to be interest payments for tax purposes. There are no capital gains or losses on money market investments. –CDs are redeemed at maturity for their original investment value.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Tax Implications Penalties paid by investors who redeem CDs prior to the maturity date are deductible for federal income tax purposes. –On his tax return, the taxpayer must report the gross amount of interest paid or credited to his account during the year without subtracting the penalty. –The penalty is deducted when calculating adjusted gross income. –The entire penalty may be deducted even if it exceeds interest income. –The gross interest and the penalty amount are reported to the taxpayer on Form 1099-INT by the financial institution issuing the certificate.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 Tax Implications Forgone interest in the event of a premature redemption is not deductible. Money market funds are available that specialize in short-term, tax-exempt investments. –Interest earned on such investments is tax free. Money market funds are exempt from the requirement that certain pass-through entities report to shareholders (as income) their shares of expenses of the fund.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 Alternatives Direct purchase of Treasury bills –The timing of maturities, safety of principal, and amount of required investment are comparable to investing in bank CDs. –Exempt from state income tax –U.S. Treasury bills, notes, and bonds are the very safest investments available and therefore typically pay slightly lower rates of interest than bank savings accounts or CDs. Short-term “investment notes” from corporations, such as financial service firms –Typical maturities range from three months to one year. –They generally possess higher risk and higher return than CDs of comparable maturity.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 Alternatives Money market deposit accounts –Offered by commercial banks, savings and loans, and mutual savings banks –Lower interest rates than money market mutual funds –Convenient because they can be obtained at the same location where the investor banks and is known –Federally insured, subject to insurance limits and account ownership titles Direct purchase of Treasury bills, commercial paper, or other similar instruments –Does not typically provide the diversification or professional management available from a money market fund

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company20 Where and How do I get it? Certificates of Deposit –Virtually all commercial banks, savings and loans, mutual savings banks, credit unions, and similar financial institutions provide CDs. –The investor makes a deposit with the bank and is issued a certificate. An investor already dealing with the bank can call the institution to obtain rate quotations and decide on the maturity date and amount to be purchased. His/her existing account is charged, and the bank holds the certificate in safekeeping.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company21 Where and How do I get it? Certificates of Deposit –CDs are automatically rolled over if they are not “cashed out” at maturity. They are rolled over into another certificate of maturity with a similar maturity, but at the bank’s current rate of interest. –It is recommended that large investment amounts are spread over multiple certificates. Part of the investment can be redeemed without disturbing the other certificates or paying the premature withdrawal penalty on the entire amount. –Diversification by bank and geographic location enhances safety of principal and convenience.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company22 Where and How do I get it? Money Market Funds –Almost all major brokerage firms make money market funds available to their customers. These firms encourage customers to leave the proceeds of any security sales or any dividends or interest received in the account on deposit in these funds. –Many brokerage firms include a money market account in comprehensive investment packages in order to keep excess cash balances fully invested at all times. –Almost all mutual fund organizations offer a money market fund, which enables investors to move assets within a “family of funds” conveniently, quickly, and with minimal cost.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company23 What Fees or Other Acquisition Costs Are Involved? Normally, no specific fees or acquisition costs are associated with the purchase of CDs or money market funds. Premature redemption fees are assessed on most CDs. –A lower interest rate may also be paid for the period of investment. There may be a management fee based on the total value of the assets owned by the money market fund. –This fee often ranges from 0.2% - 0.7%. –It is deducted directly from the assets invested. An annual account fee may be deducted from low balance accounts. –This fee is usually $10 annually on accounts below $10,000.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company24 How Do I Select the Best of Its Type? CDs –Investors should compare the interest rates offered by several institutions for a given maturity. –Higher rates are often available from banks and thrift institutions in other parts of the country. –Information on interest rates offered by out-of-state institutions may be found in: –Barron’s –The Wall Street Journal –The New York Times –The Investors Business Daily –Others

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company25 How Do I Select the Best of Its Type? Money Market Funds –Investors should compare the yields offered by various funds. Returns are generally stated in terms of the average yield paid by the fund during the past seven days or during the past 30 days. –Funds should be selected with short average maturities. –Investors should also check rating services that evaluate the quality of securities in a money market fund’s portfolio.

Cash and Cash Equivalents Chapter 1 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company26 Where Can I Find Out More About It? The various financial institutions offering the investment products Financial newspapers and magazines –Wall Street Journal –New York Times –Barron’s –Investor’s Business Daily Internet sources –Bloomberg –MSN Money Central –Yahoo Finance –iMoneyNet,Inc. –Bankrate