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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 finan-

cially. Sandra always writes small checks. They

might be $15 for gas, $5 for lunch, or $40 for

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. Unfor-

tunately, 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!

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.

C H A P T E R

6Managing Your Money

159

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.

BACKGROUND ON MONEY MANAGEMENT

Money management describes the decisions you make over a short-term periodregarding your cash inflows and outflows. It is separate from decisions oninvesting funds for a long-term period (such as several years) or borrowingfunds for a long-term period. Instead, it focuses on maintaining short-terminvestments to achieve both liquidity and an adequate return on your invest-ments, as explained next.

LIQUIDITYAs discussed in Chapter 1, liquidity refers to your ability to cover any short-term cash deficiencies. Recall that the personal cash flow statement determinesthe 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 personalcash flow statement because it determines how to use excess funds, or how toobtain funds if your cash inflows are insufficient. You should strive to maintaina sufficient amount of funds in liquid assets such as a checking account or sav-ings account to draw on when your cash outflows exceed your cash inflows. Inthis 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 creditcards provide temporary free financing from the time you make purchases untilthe date when your payment is due. If you have insufficient funds to pay theentire credit card balance when the bill is due, you may pay only a portion ofyour balance and finance the rest of the payment. The interest rate is usuallyquite high, commonly ranging from 8 to 20 percent. Maintaining liquid assetsthat you can easily access when you need funds allows you to avoid using creditand paying high finance charges.

160 M A N A G I N G Y O U R M O N E Y

money managementA series of decisions madeover a short-term periodregarding cash inflows andoutflows.

liquidityYour ability to cover anycash deficiencies that youmay experience.

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E X A M P L E

Stephanie Spratt’s cash inflows are $2,500 per month after taxes. Her cash outflowsare normally about $2,100 per month, leaving her with $400 in cash each month. Thismonth she expects that she will have an extra expense of $600; therefore, her cashoutflows will exceed her cash inflows by $200. She needs a convenient source offunds to cover the extra expense.

Liquidity is necessary because there will be periods when your cash inflowsare not adequate to cover your cash outflows. But there are opportunity costswhen you maintain an excessive amount of liquid funds. A portion of thosefunds could have been invested in less liquid assets that could earn a higherreturn 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 degreeof liquidity.

ADEQUATE RETURNWhen you maintain short-term investments, you should strive to achieve thehighest possible return. The return on your short-term investments is dependenton 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 thereturn that you expect. For example, you could maintain a large amount of cashin 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 achieveboth liquidity and an adequate return, you should consider investing in multi-ple money market investments with varied returns and levels of liquidity.

MONEY MARKET INVESTMENTS

Common investments for short-term funds include the following money marketinvestments:

■ Checking account

■ NOW account

■ Savings deposit

■ Certificate of deposit

■ Money market deposit account (MMDA)

■ Treasury bills

■ Money market fund

■ Asset management account

MONEY MARKET INVESTMENTS 161

All of these investments except Treasury bills and money market funds areoffered by depository institutions and are insured for up to $100,000 in theevent of default by the institution. In this section, we’ll examine each of theseinvestments in turn, and focus on their liquidity and typical return.

CHECKING ACCOUNTIndividuals deposit funds in a checking account at a depository institution towrite checks or use their debit card to pay for various products and services. Achecking account is a very liquid investment because you can access the funds(by withdrawing funds or writing checks) at any time.

Overdraft Protection. Some depository institutions offer overdraft protec-tion, which protects a customer who writes a check for an amount that exceedsthe 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 balanceof only $100, the depository institution will provide overdraft protection bymaking a loan of $200 to make up the difference. Without overdraft protection,checks written against an insufficient account balance bounce, meaning thatthey are not honored by the depository institution. In addition, a customer whowrites a check that bounces may be charged a penalty fee by the financial insti-tution. 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 neverreceived by the payee, you may request that the financial institution stop pay-ment, which means that the institution will not honor the check if someone triesto cash it. In some cases, a customer may even stop payment to prevent therecipient from cashing a check. For example, if you write a check to pay for


overdraft protectionAn arrangement thatprotects a customer whowrites a check for anamount that exceeds thechecking account balance;it is a short-term loan fromthe depository institutionwhere the checkingaccount is maintained.

stop paymentA financial institution’snotice that it will nothonor a check if someonetries to cash it; usuallyoccurs in response to arequest by the writer ofthe check.

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home repairs, but the job is not completed, you may decide to stop payment onthe check. Normally, a fee is charged for a stop payment service.

Fees. Depository institutions may charge a monthly fee such as $15 per monthfor providing checking services unless the depositor maintains a minimum bal-ance in the checking account or a minimum aggregate balance in other accountsat that institution. Some financial institutions charge a fee per check writteninstead of a monthly fee. The specific fee structure and the rules for waiving thefee vary among financial institutions, so you should compare fees before youdecide where to set up your checking account.

No Interest. A disadvantage of investing funds in a checking account is thatthe funds do not earn any interest. For this reason, you should keep only enoughfunds in your checking account to cover anticipated expenses and a small excessamount in case unanticipated expenses arise. You should not deposit morefunds in your checking account than you think you may need, because you canearn interest by investing in other money market investments.

NOW ACCOUNTAnother deposit offered by depository institutions is a negotiable order of with-drawal (NOW) account. An advantage of a NOW account over a traditionalchecking account is that it pays interest, although the interest is relatively lowcompared with many other bank deposits. The depositor is required to main-tain a minimum balance in a NOW account, so the account is not as liquid asa traditional checking account.

E X A M P L E

Stephanie Spratt has a checking account with no minimum balance; she is consid-ering opening a NOW account that requires a minimum balance of $500 and offersan interest rate of 3 percent. She has an extra $800 in her checking account that shecould transfer to the NOW account. How much interest would she earn over oneyear in the NOW account?

Interest Earned � Deposit Amount � Interest Rate

� $800 � .03

� $24.

Stephanie would earn $24 in annual interest from the NOW account, versus zerointerest from her traditional checking account. She would need to maintain the $500minimum balance in the NOW account, whereas she has the use of all of the fundsin her checking account. She decides to leave the funds in the checking account, asthe extra liquidity is worth more to her than the $24 she could earn from the NOWaccount.


NOW (negotiableorder of withdrawal)accountA type of deposit offeredby depository institutionsthat provides checkingservices and pays interest.

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SAVINGS DEPOSITTraditional savings accounts offered by a depository institution pay a higherinterest 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 sav-ings account does not provide checking services. It is less liquid than a checkingaccount or a NOW account because you have to go to the institution or to anATM to access funds, which is less convenient than writing a check. The inter-est rate offered on savings deposits varies among depository institutions. Manyinstitutions quote their rates on their Web sites.

E X A M P L E

Stephanie Spratt wants to determine the amount of interest that she would earn overone year if she deposits $1,000 in a savings account that pays 4 percent interest.


� $1,000 � .04

� $40.

Although the interest income is attractive, she cannot write checks on a savingsaccount. As she expects to need the funds in her checking account to pay bills in thenear future, she decides not to switch those funds to a savings account at this time.

CERTIFICATE OF DEPOSITAs mentioned in Chapter 5, a certificate of deposit (CD) offered by a depositoryinstitution specifies a minimum amount that must be invested, a maturity dateon which the deposit matures, and an annualized interest rate. Common matu-rity dates of CDs are one month, three months, six months, one year, threeyears, and five years. CDs can be purchased by both firms and individuals. CDsthat have small denominations (such as $10,000 or less) are sometimes referredto as retail CDs because they are more attractive to individuals than to firms.

Return. Depository institutions offer higher interest rates on CDs than on sav-ings deposits. The higher return is compensation for being willing to maintainthe investment until maturity. Interest rates are quoted on an annualized(yearly) basis. The interest to be generated by your investment in a CD is basedon the annualized interest rate and the amount of time until maturity. The inter-est rates offered on CDs vary among depository institutions.

E X A M P L E

A three-month (90-day) CD offers an annualized interest rate of 6 percent andrequires a $5,000 minimum deposit. You want to determine the amount of interestyou would earn if you invested $5,000 in the CD. Since the interest rate is annual-ized, you will receive only a fraction of the 6 percent rate because your investmentis for a fraction of the year:


retail CDsCertificates of deposit thathave small denominations(such as $10,000 or less).

Interest Earned � Deposit Amount � Interest Rate � Adjustment for InvestmentPeriod

� $5,000 � .06 � 90/365

This process can be more easily understood by noting that the interest rate is appliedfor only 90 days, whereas the annual interest rate reflects 365 days. The interest ratethat 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 � 90/365

� .0148 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 depositamount:


� $5,000 � .0148

� $73.97.

Liquidity. A penalty is imposed for early withdrawal from CDs, so thesedeposits are less liquid than funds deposited in a savings account. You shouldconsider a CD only if you are certain that you will not need the funds until afterit matures. You may decide to invest some of your funds in a CD and otherfunds in more liquid assets.

Choice among CD Maturities. CDs with longer terms to maturity typicallyoffer higher annualized interest rates. However, CDs with longer maturities tieup your funds for a longer period of time and are therefore less liquid. Yourchoice of a maturity for a CD may depend on your need for liquidity. For exam-ple, if you know that you may need your funds in four months, you could investin a three-month CD and then place the funds in a more liquid asset (such asyour checking account or savings account) when the CD matures. If you do notexpect to need the funds for one year, you may consider a one-year CD.

FOCUS ON ETHICS: RISKY DEPOSIT RATESConsider the case of a financial institution that promises an annual rate of inter-est to depositors that is 4 percent higher than the certificate of deposit ratesoffered by local banks.

While this certificate sounds appealing, it is probably much riskier than youthink. A firm is not going to offer an interest rate of 4 percent more than otherinterest-bearing investments unless it needs to pay such a high return in orderto compensate for risk. Inquire if the deposit is insured by the FDIC. While youmight possibly earn 4 percent more on this investment than by depositing thefunds at a bank, you might also lose 100 percent of your money if the financialinstitution goes bankrupt. There are many investment companies that prey on


individuals (especially the elderly) who presume that because an investmentsounds like a bank deposit, it is insured and safe. If an investment sounds toogood to be true, it probably is.

MONEY MARKET DEPOSIT ACCOUNT (MMDA)A money market deposit account (MMDA) is a deposit account offered by adepository institution that requires a minimum balance to be maintained, hasno maturity date, pays interest, and allows a limited number of checks to bewritten each month. The specific details vary among financial institutions. Forexample, an account might require that a minimum balance of $2,500 be main-tained over the month and charge a $15 per month fee in any month when theminimum balance falls below that level.

An MMDA differs from a NOW account in that it provides only limitedchecking services while paying a higher interest rate than that offered on NOWaccounts. Many individuals maintain a checking account or NOW account tocover most of their day-to-day transactions and an MMDA to capitalize on thehigher interest rate. Thus, they may maintain a larger amount of funds in theMMDA 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 amountof checks that can be written.

TREASURY BILLSAs 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 hasreceived in taxes, it borrows funds by issuing Treasury securities. Individuals canpurchase Treasury securities through a brokerage firm. Treasury securities areoffered with various maturities, such as three months, six months, one year, 10years, and 30 years. For money management purposes, individuals tend to focuson Treasury bills (T-bills), which are Treasury securities that will mature in one yearor 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 investin a T-bill and hold it until maturity, you earn a capital gain, which is the dif-ference between the par value of the T-bill at maturity and the amount you paidfor the T-bill. Your return on the T-bill is the capital gain as a percentage of yourinitial investment.

E X A M P L E

An investor pays $9,400 to purchase a T-bill that has a par value of $10,000 and aone-year maturity. When the T-bill matures, she receives $10,000. The return frominvesting in the T-bill is:

Return on T-Bill � $10,000 � $9,400$9,400

� 6.38%.


money marketdeposit account(MMDA)A deposit offered by adepository institution thatrequires a minimumbalance, has no maturitydate, pays interest, andallows a limited number ofchecks to be written eachmonth.

Treasury securitiesDebt securities issued bythe U.S. Treasury.

Treasury bills (T-bills)Treasury securities withmaturities of one year orless.

When measuring returns on investments, you should annualize the returnsso that you can compare returns on various investments with different maturi-ties. An investment over a one-month period will likely generate a smaller dol-lar amount of return than a one-year investment. To compare the one-monthand one-year investments, you need to determine the annualized yield (or per-centage return) on each investment.

For an investment that lasts three months (one-fourth of a year), multiplyby 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 mostprecise method of annualizing a return is to multiply the return by 365/N,where N is the number of days the investment existed.

E X A M P L E

An investor pays $9,700 to purchase a T-bill with a par value of $10,000 and a matu-rity of 182 days. The annualized return from investing in the T-bill is:

Return on T-Bill �$10,000 � $9,700

�365

$9,700 182

� 6.20%.

Secondary Market. There is a secondary market for T-bills where they can besold before their maturity with the help of a brokerage firm. This secondarymarket also allows individuals to purchase T-bills that were previously owned


6.1 Financial Planning Online: Deposit Rates Offered by Banks

Go to:http://www.bankrate.com/brm/rate/dep_home.asp

This Web site provides:information on the highestinterest rates offered ondeposits by banks acrossthe United States as wellas in your specific city.

secondary marketA market where existingsecurities such as Treasurybills can be purchased orsold.

link167.html

by someone else. The return on a T-bill is usually slightly lower than the returnon a CD with the same maturity, but T-bills are more liquid because they havea 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 whatyou sold the T-bill for and what you paid for the T-bill. Your return is this cap-ital gain as a percentage of your initial investment.

E X A M P L E

An investor purchases a T-bill for $9,700 and sells the T-bill in the secondary market60 days later for a price of $9,820. The annualized return is:

Return on T-Bill �$9,820 � $9,700

�365

$9,700 60

� 7.53%.

Quotations. The prices of various T-bills and the returns they offer for hold-ing them until maturity are quoted in financial newspapers and online.

MONEY MARKET FUNDS (MMFS)Money market funds (MMFs) pool money from individuals to invest in securi-ties that have a short-term maturity, such as one year or less. In fact, the averagetime remaining to maturity of debt securities held in an MMF is typically lessthan 90 days. Many MMFs invest in short-term Treasury securities or in whole-sale CDs (in denominations of $100,000 or more). Investors can invest in MMFsby sending a check for the amount they wish to have invested for them. SomeMMFs invest mainly in commercial paper, which consists of short-term debtsecurities issued by large corporations. Commercial paper typically generates aslightly higher interest rate than T-bills. Money market funds are not insured, butmost 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 ofchecks on their accounts each month. Often the checks must exceed a minimumamount (such as $250). Individuals may use the checking account associatedwith an MMF to cover large expenditures, while maintaining a regular checkingaccount to cover smaller purchases. Many individuals invest in an MMF so thatthey can earn interest until the money is needed. Some MMFs are linked withother accounts so that the money can earn interest until it is transferred toanother account. For example, many brokerage accounts allow investors to placeany unused funds in an MMF until the funds are used to purchase stock.

E X A M P L E

Assume that you set up an account with $9,000 to purchase stock at a brokeragefirm on May 1. On that day, you purchase 100 shares of a stock priced at $50. To


money market funds(MMFs)Accounts that pool moneyfrom individuals and investin securities that have ashort-term maturity, suchas one year or less.

commercial paperShort-term debt securitiesissued by largecorporations that typicallyoffer a slightly higherreturn than Treasury bills.

cover the purchase, the brokerage firm withdraws $5,000 (computed as $50 � 100shares) from your account. You still have $4,000 that you have not used, which isplaced in a specific MMF account at the brokerage firm. This MMF offers the samelimited check-writing services as other MMFs. The money will sit in that accountuntil you use it to purchase stock or write checks against the account. Assuming thatthe 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 thataccount over the month when the funds were not used:

Amount Invested in MMF � Interest Rate per Month � Interest Earned in 1 Month

$4,000 � .005 � $20.

Therefore, the MMF account balance increases by $20 to $4,020 because the fundsearned interest. Any unused balance will continue to earn interest until you use it topurchase stock or write checks against the account.

Money Market Fund Quotations. Every Thursday the Wall Street Journalpublishes the yields provided by various money market funds, as shown inExhibit 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, theannualized yield generated by the fund; and the fourth column, the size of thefund (measured in millions of dollars). As an example, the Janus fund thatinvests in government securities is highlighted in Exhibit 6.1. This fund’sinvestments 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.

an annualized yield of .89 percent to its investors over the last 7 days. It has$427 million in assets.

ASSET MANAGEMENT ACCOUNTAn asset management account combines deposit accounts with a brokerageaccount that is used to buy or sell stocks. The advantage of an asset manage-ment account is that it provides a single consolidated statement showing theending balances and activity of all the accounts. Asset management accounts areavailable at some depository institutions and brokerage services. The financialinstitutions that offer these accounts require that the sum of all the accounts inthe asset management account exceed some minimum amount, such as $15,000.One of the special benefits that may be offered to individuals who maintain anasset management account is a so-called sweep account that sweeps any unusedbalance in the checking account into the money market account at the end ofthe day. Any unused balance remains available for writing checks and earnsinterest in the meantime.

COMPARISON OF MONEY MARKET INVESTMENTSThe various money market investments are compared in Exhibit 6.2. Noticethat money market investments that offer a higher return tend to have lessliquidity.

The relationship between the returns and the liquidity of money marketinvestments is illustrated graphically in Exhibit 6.3. Checking accounts offer themost liquidity but provide no return. At the other extreme, a one-year CD pro-vides the highest return but has less liquidity than the other money marketinstruments.


asset managementaccountAn account that combinesdeposit accounts with abrokerage account andprovides a singleconsolidated statement.

Money Market Investment Advantages DisadvantagesChecking 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

Exhibit 6.2 Comparison of Money Market Investments

RISK OF MONEY MARKET INVESTMENTS

Before you consider investing short-term funds in various money market instru-ments, you must factor in your exposure to risk, or the uncertainty surround-ing the potential return. Money market investments are vulnerable to threetypes of risk: (1) credit risk, (2) interest rate risk, and (3) liquidity risk.

RISK OF MONEY MARKET INVESTMENTS 171

Exhibit 6.3 Comparison of the Liquidity and Returns of Money Market Instruments

Return

Checking Account

One-Year CD

Three-Month CD

Three-Month T-bill

Savings Account

MMDA

NOW Account

Liquidity

6.2 Financial Planning Online: Impact of Different Deposit Rates on Your Wealth

Go to:http://cgi.money.cnn.com/tools/savingscalc/savingscalc.html

This Web site provides:Estimates of future savingsthat you will accumulateover time at different inter-est rates in taxable or non-taxable accounts adjustedfor inflation.

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CREDIT RISKWhen 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 notrepay on a timely basis. The borrower may make late payments or may evendefault on the credit; in that event, you will receive only a portion (or none) ofthe money you invested. MMFs that invest in large deposits of financial insti-tutions that are insured only up to $100,000 and in short-term securities issuedby firms are exposed to credit risk.

Other money market investments are insulated from credit risk. For exam-ple, deposits at commercial banks and savings institutions are insured up to$100,000 by the Federal Deposit Insurance Corporation (FDIC). Treasury secu-rities are backed by the federal government.

INTEREST RATE RISKInterest rate risk is the risk that the value of an investment could decline as aresult of a change in interest rates.

E X A M P L E

Suppose that you purchase a one-year T-bill that offers you a return of 5 percent overthe next year. Three months after you purchase the Treasury security, interest ratesrise. Now you are disappointed that you locked in this investment at 5 percent


credit risk (or default risk)The risk that a borrowermay not repay on a timelybasis.

interest rate riskThe risk that the value ofan investment coulddecline as a result of achange in interest rates.

6.3 Financial Planning Online: Identifying Insured Investments

Go to:http://www.chicagofed.org/consumer_information/what_you_should_know_about_internet_banking.cfm

Click on:Banking Consumers’Option

This Web site provides:a comparison of the differ-ent methods of investingyour money in a bank andidentifies the investmentsthat are backed by theU.S. government.

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because other investments (including existing T-bills) are now offering an annualizedreturn of about 6 percent for investors who hold the security until maturity. You cansell your T-bill in the secondary market, but you realize that investors will pay a rela-tively low price for it because they can buy new securities that offer an annualizedreturn of 6 percent. This explains why the value of a debt security decreases inresponse 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 toit until it matures. However, the return on your investment over the entire one-yearperiod will be only 5 percent even though T-bills issued after you purchased yoursecurity are offering higher returns. Neither of your two options is desirable.

Investors who wish to limit their exposure to interest rate risk can invest indebt securities that have shorter maturities. If you had held a three-month secu-rity instead of a one-year security in the previous example, you could haveredeemed your security at maturity after three months and reinvested yourmoney at the prevailing higher interest rate.

LIQUIDITY RISKRecall that liquidity represents your ability to cover any short-term cash defi-ciencies. To be liquid, an investment should be easily converted to cash. Liquid-ity risk is the potential loss that could occur as a result of converting an invest-ment to cash. For example, a retail CD has liquidity risk because it cannot besold in the secondary market. You would suffer a penalty if you tried to redeemit before maturity at the financial institution where you invested in the CD.

The liquidity risk of an investment is influenced by its secondary market. Ifa particular debt security has a strong secondary market, it can usually be soldquickly and at less of a discount than a debt security with an inactive second-ary 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 riskexhibited by the investments and (2) using your assessment of risk and yourunique financial situation to determine the optimal allocation of your short-term funds among money market investments.

RISK ASSESSMENT OF MONEY MARKET INVESTMENTSYou must consider the risk-return tradeoff before making investment decisions.The money market securities described in this chapter tend to be insulated fromcredit risk because they are insured or backed by the government. Treasurysecurities and small bank deposits are largely free from credit risk. One excep-tion is MMFs that invest in commercial paper. If the commercial paper held by

RISK MANAGEMENT OF MONEY MARKET INVESTMENTS 173

liquidity riskThe potential loss thatcould occur as a result ofconverting an investmentinto cash.

a particular MMF defaults, the return generated by the MMF will be adverselyaffected, and so will the return to investors who invested in that MMF.

As mentioned earlier, money market investments that have shorter maturi-ties have less interest rate risk. In addition, investments in MMFs tend to havethe least liquidity risk, especially when their investments focus on securities thatwill mature within the next month. Treasury securities that will mature in thenext month or so also have very little liquidity risk.

Would you invest in a high-risk security if a lower-risk security offered thesame yield? Probably not. Securities that are exposed to risk have to offer higheryields than less risky investments to attract funds from investors. The prospectof 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 investmentssubject to credit risk and for securities that are particularly vulnerable to inter-est rate risk. Recall that debt securities with shorter maturities offer lower annu-alized yields. A three-month debt security typically offers a slightly lower annual-ized yield than a one-year security. However, the debt securities with longermaturities 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 thesame maturity because the Treasury security is more liquid.

DETERMINING THE OPTIMAL ALLOCATION OF MONEY MARKET INVESTMENTSIn general, your money management should be guided by the following steps:

1. Anticipate your upcoming bills, and ensure that you have sufficient fundsin your checking account.

2. Estimate the additional funds that you might need in the near future, andconsider investing them in an investment that offers sufficient liquidity(such as an MMF). You may even keep a little extra in reserve here forunanticipated 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 allo-cation for another individual. If your future net cash flows will be far short ofupcoming expenses, you will need to keep a relatively large proportion of fundsin a liquid investment (such as a checking account or a NOW account). Anotherperson who has sufficient cash flows to cover expenses will not need much liquid-ity. The difference is illustrated in Exhibit 6.4. Even though the two individualshave the same level of net cash flows, one person must maintain more liquiditythan the other.

Your decision on how to invest your short-term funds (after determininghow much money to maintain in your checking account) should account foryour willingness to tolerate risk. If you want to minimize all forms of risk, youmay simply consider investing all of your funds in an MMF that always focuseson Treasury securities maturing within a month or less. However, you will likely


improve on the yield if you are willing to accept some degree of risk. For exam-ple, if you know that you will not need your funds for at least six months anddo not expect interest rates to rise substantially over that period, you might con-sider investing your funds in a six-month retail CD. A compromise would be toinvest a portion of your short-term funds in the six-month retail CD and theremaining funds in the MMF that focuses on Treasury securities. The CD offersyou a higher expected return (although less liquidity), while the MMF offersyou liquidity in case you need funds immediately.

E X A M P L E

Stephanie Spratt has $2,000 available to allocate to money market investments. Sheknows that she will need $400 to cover several small bills in the next week and mayalso need $600 in a month or so to pay for repairs on her car engine. She does notexpect to need the other funds for at least six months. Her financial institution offersthe 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

RISK MANAGEMENT OF MONEY MARKET INVESTMENTS 175

Exhibit 6.4 How Liquidity Is Affected by Anticipated Expenses

Net CashFlows

Allocateto Liquid

Funds

Allocateto

NonliquidFunds

CoverAnticipatedExpenses

Long-TermInvestments

Long-TermInvestments

Net CashFlows

Allocateto

NonliquidFunds

Allocateto Liquid

Funds

CoverAnticipatedExpenses

Stephanie’s existing checking account has a balance close to zero. She also has anMMF with a balance of $300, which she must maintain to meet the minimum bal-ance. She will first focus on meeting her liquidity needs and then decide how toinvest the remaining funds that are not needed to cover possible expenses. Shedecides to allocate $400 to her checking account so that she can write severalchecks to cover her upcoming bills. It is not worthwhile to invest these funds else-where as she will need the funds soon, and the checking account is the only invest-ment that will allow her to write several small checks.

She knows that she might need another $600 in the near future for car repairs, butwants to earn as high a return as possible until she needs the money. She immedi-ately eliminates the MMDA from consideration because it would require a minimumbalance of $2,500. She decides to invest the $600 in her MMF. She can write a checkfrom this account to cover the car repairs; meanwhile, the funds invested in theMMF will earn 4 percent interest on an annualized basis.

Stephanie now has $1,000 remaining to allocate and anticipates that she will notneed 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 $1,000in a six-month CD, so that she can increase liquidity while still earning a relativelyhigh return.

If Stephanie had excess funds that she would not need for a few years, she wouldconsider investing the residual in other investments (such as stocks) that offer ahigher potential return. The potential return and risk of these other investments arediscussed in Part 5.

HOW MONEY MANAGEMENT FITS WITHIN YOUR FINANCIAL PLAN

The following are the key money management decisions that you should includein 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 unantici-pated expenses?

3. How should you invest any remaining funds among money marketinvestments?

By making proper decisions, you can minimize your use of credit and can max-imize the return on your liquid assets. As an example, Exhibit 6.5 shows howmoney market decisions apply to Stephanie Spratt’s financial plan.


DISCUSSION QUESTIONS 177

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 MethodMonthly 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 thecredit card balance by check once amonth.

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.

Exhibit 6.5 How Money Management Fits within Stephanie Spratt’s Financial Plan

DISCUSSION QUESTIONS1. How would Stephanie’s money management deci-

sions be different if she were a single mother of twochildren?

2. How would Stephanie’s money management deci-sions be affected if she were 35 years old? If shewere 50 years old?


SUMMARYMoney management involves the selection of short-term investments that satisfy your liquidity needsand also provide you with an adequate return onyour investment. It is challenging because the short-term investments that offer relatively high returnstend to have less liquidity.

Popular short-term investments considered formoney management include checking accounts,NOW accounts, savings accounts, CDs, MMDAs,Treasury bills, money market funds, and asset man-agement accounts. Checking accounts and NOWaccounts offer the most liquidity. CDs and T-billsoffer the highest return.

The risks related to money market investments arecredit (default) risk, interest rate risk, and liquidityrisk. The money market investments offered by de-pository institutions are insured and insulate youfrom the risk that the institution could default. In-vestments in T-bills have no default risk becausethey are backed by the federal government. Moneymarket securities tend to have a low level of interestrate risk because they have short-term maturities.They also have relatively low liquidity risk because ofthe short-term maturities of their assets.

When applying money management, you shouldfirst anticipate your expenses in the next month and

maintain enough funds in your checking account tocover those expenses. In addition, you should esti-mate the potential level of unanticipated expenses(such as possible car repairs) and maintain enoughfunds in a short-term investment such as a moneymarket fund to cover these expenses. Finally, investthe remaining funds to earn a high return within yourlevel of risk tolerance.

INTEGRATING THE KEY CONCEPTSYour money management decisions determine yourlevel of liquidity and also affect other parts of your fi-nancial plan. If your money market investmentshave a high degree of liquidity, you have more fundsthat you can use. The amount of liquidity that youmaintain is partly determined by your budgeting de-cisions (Part 1) because you will need more liquidityif your cash outflows are expected to exceed yourcash inflows.

The decision to maintain a high degree of liquiditycan affect your financing decisions (Part 3) becausethe more of your cash that you can use, the less youwill need to rely on loans. Your money managementwill also affect your investment decisions (Part 5)because you can focus on investments that are notliquid if you already have sufficient liquidity fromyour money market investments.

1. Financial

Planning Tools

(Budgeting, TimeValue, Tax Planning)

5. Investing

(Stocks, Bonds, Mutual Funds)

2. LiquidityManagement

(Banking, Money Management,

Credit Management)

3. Financing

(Personal Loans, Mortgages)

Your Money

Management

Decisions

6. Retirement and

Estate Planning

(Retirement Planning, Estate Planning)

4. Protecting Your

Assets and Income

( Insurance)

FINANCIAL PLANNING PROBLEMS 179

REVIEW QUESTIONS1. Define money management. How does it differ

from long-term investment or long-term borrowingdecisions?

2. What is liquidity? How is your personal cash flowstatement used to help manage your liquidity?How does money management relate to the cashflow statement?

3. Name some ways an individual might handle acash flow deficiency. Which way would be prefer-able? Why?

4. What is the opportunity cost of having excessiveamounts of liquid funds?

5. What two factors affect the return on short-terminvestments? What investments should you con-sider to achieve liquidity and an adequate return?

6. Why do individuals use checking accounts? Whatis the disadvantage of having funds in a checkingaccount? Explain overdraft protection and stoppayment orders. Are all bank fee structures thesame?

7. What is a NOW account? How is it different froma regular checking account? How does a savingsaccount compare with a NOW account?

8. What terms does a financial institution specify forcertificates of deposit? Why are rates on CDshigher than those on savings accounts? What fac-tor would most affect your choice of maturity dateon a CD?

9. How does a money market deposit account(MMDA) differ from a NOW account? Whenmight a depositor use an MMDA?

10. What are Treasury securities? What is a T-bill?How is it denominated? How do you earn a returnon a T-bill? How is the return calculated?

11. Compare the interest rates offered on T-bills andCDs. Which type of investment is more liquid?Why?

12. What are money market funds (MMFs)? Whattypes of securities do they invest in? What iscommercial paper? Are MMFs risky investments?Are MMFs liquid?

13. What is an asset management account? Discussthe advantages of such an account as well as itsrequirements.

14. Compare the return and liquidity of the variousmoney market investments. Give specific exam-ples.

15. What are the three types of risk money market in-vestments are vulnerable to?

16. Generally compare the money market invest-ments described in this chapter in terms of theirvulnerability to credit risk, interest rate risk, andliquidity risk. Provide some examples of specificsecurities. What is the risk-return tradeoff forthese investments?

17. What steps should you take to determine the bestallocation of your money market investments?What factors should you consider in determiningyour allocation?

FINANCIAL PLANNING PROBLEMS1. Teresa has just opened a NOW account that pays

3.5 percent interest. If she maintains a minimumbalance of $500 for the next 12 months, howmuch interest will she earn?

2. Nancy is depositing $2,500 in a six-month CD thatpays 4.25 percent interest. How much interest willshe accrue if she holds the CD until maturity?

3. Travis has invested $3,000 in a three-month CD at4 percent. How much will Travis have when the CDmatures?

4. Teddy has invested $10,000 in an 18-month CDthat pays 6.25 percent. How much interest willTeddy 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-billto maturity?

6. Bart is a college student who has never investedhis funds. He has saved $1,000 and has decided toinvest the funds in a money market fund with anexpected return of 2.0 percent. Bart will need thefunds in one year. Brokerage commissions will costBart $20 at the time he withdraws the funds in oneyear. How much money will Bart have in one yearas a result of this investment?

7. Davis has $20,000 excess cash to invest. He canpurchase a $20,000 T-bill for $19,400 or two$10,000 T-bills for $9,600 each. Which will give himthe better return?

Money market investments provide vehicles to as-sist you in accomplishing your short-term financialgoals. Refer back to the three to five short-termgoals you established in Chapter 1. For each goal,rate the importance (high, medium, or low) of thefollowing items:

1. Liquidity

2. Risk

3. Fees/minimum balance

4. Return

BUILDING YOUR OWN FINANCIAL PLAN


8. Stacy purchased a $40,000 T-bill for $38,400. Afew 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 MMDAthat pays 5 percent interest. On October 31, Amyinvested $2,000 in a three-month CD that pays 6percent. At the end of the year, how much inter-est will Amy have earned, assuming she hasn’ttaken anything out of the money market depositaccount?

11. Thomas can invest $10,000 by purchasing a 1-year T-bill for $9,275, or he can place the $10,000in a 12-month CD paying 8 percent. Which invest-ment will provide the higher return? In addition toreturn, what else should Thomas consider whenmaking his investment decision?

FINANCIAL PLANNING ONLINE EXERCISES1. Go to http://www.calcbuilder.com/cgi-bin/calcs/

SAV2.cgi/FinanCenter. Using this site, you can findthe answer to the question, “How Much Will MySavings Be Worth?”a. By inputting an investment amount, the

monthly deposit, the return, the period of in-vestment, the tax rate, and the inflation rate,you can calculate the value of your investment.Input $5,000 as the initial investment, $100 forthe monthly deposit, 6 percent for the return,25 percent for the federal tax rate, 6 percent forthe state tax rate, 3 percent for the inflation

rate. How much will your investment be worthin 20 years? Click on the Graphs option to viewthe results graphically.

b. Now change the monthly deposit to $300. Howmuch will your investment be worth in 20years?

c. Now change the period of investment to 30years. How much more money will you be ableto accumulate in 30 years as opposed to 20,using the original $100 monthly depositamount?

d. Now change the rate you can earn on your in-vestment from 6 to 8 percent and evaluate theresults and graph using the original inputs.

2. Go to http://www.calcbuilder.com/cgi-bin/calcs/SAV2.cgi/FinanCenter.a. Determine how much you need to save for a

major purchase. Input $8,000 as the amountyou need, $1,000 as what you will invest now, a$100 monthly deposit, 36 months for the sav-ings period, 6 percent return, 25 percent federaltax rate, and 6 percent state tax rate. Will yourinvesting plan allow you to achieve your goal? Ifnot, how should you revise your plan? Click onGraphs to view the results graphically.

b. To accumulate $15,000 for a down payment ona house, you plan to save $150 per month overa five-year period at an 8 percent return. Willyour plan work? If not, how should you reviseit? Assume the same tax rates as in part a.

c. So, you want to be a millionaire. Can you accu-mulate $1 million to use for your retirementwith an initial investment of $25,000, monthlyinvestments of $750, and a 7 percent returnover a 30-year period? If not, what adjustmentscan you make? Assume the same tax rates asin part a.

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THE SAMPSONS—A CONTINUING CASE 181

Recall from Chapter 2 that the Sampsons currentlyhave about $300 in cash and $1,700 in their check-ing account. This amount should be enough to coverupcoming bills. The Sampsons have just started sav-ing $800 per month. This money will be placed inCDs every month, which they chose in Chapter 5.These funds, earmarked for a down payment on acar and their children’s college education, are notavailable to the Sampsons for the maturity of the CD.Review the Sampsons’ recent cash flow statementand personal balance sheet. The monthly savings of$800 are not included in the cash flow statement.

The Sampsons’ Personal Cash Flow Statement

Cash Inflows (Monthly) $4,000

Cash Outflows (Monthly)

Rent $900

Cable TV 60

Electricity and water 80

Telephone 70

Groceries 500

Health care insurance and expenses 160

Clothing 300

Car expenses (insurance, maintenance, and gas) 400

School expenses 100

Recreation 700

Total Cash Outflows $3,270

Net Cash Flows (Monthly) �$730

The Sampsons’ Personal Balance Sheet

Assets

Liquid Assets

Cash $300

Checking account 1,700

Savings account 0

Total liquid assets $2,000

Household Assets

Home $130,000

Cars 9,000

Furniture 3,000

Total household assets $142,000

Investment Assets

Stocks 0

Total investment assets 0

Total Assets $144,000

THE SAMPSONS—A CONTINUING CASE

Now, rank each of the money market investmentsas good, fair, or poor with respect to how they meetyour four goals. For example, a checking accountmight be ranked good for liquidity, fair for risk, andpoor for fees and return. Once you have establishedthe priority of your goals and ranked the money mar-ket investments, select the money market invest-ment that will best help you achieve each short-termgoal. Enter the information on the template for this

chapter in the Financial Planning Workbook and onthe CD-ROM.

Note: You may find it necessary to revisit some ofthe financial institutions involved in your Chapter 5analysis to gather the information necessary to se-lect the most appropriate money market investmentfor each short-term goal.


True/False:1. Money management involves a series of decisions

you make over a long-term period regarding your cashinflows and outflows.

2. Money management is related to the cash budget be-cause it determines how you use excess funds or ob-tain funds if your cash outflows exceed your cash in-flows.

3. Liquidity is an individual’s ability to cover any cash de-ficiencies that he may experience.

4. Some depository institutions allow for overdraft pro-tection, which protects a customer who writes acheck for an amount that exceeds the CD balance.

5. An advantage of a NOW account over a traditionalchecking account is that it pays interest, although theinterest is relatively low compared with many other in-vestments.

6. A traditional savings account offered by a depositoryinstitution pays an interest rate on deposits that islower than that offered on a NOW account.

7. Common maturity dates of retail CDs are 7 years, 10years, and 20 years.

8. Five-year CDs are highly liquid.

9. An MMDA differs from a NOW account in that it pro-vides only limited checking services while paying ahigher interest rate than that offered on NOW ac-counts.

10. Interest rate risk is the risk that the value of an in-vestment could decline as a result of a change in in-terest rates.

11. Although liquidity is necessary, an opportunity cost isincurred when maintaining an excessive amount ofliquid funds.

Multiple Choice:1. Individuals with short-term funds would probably not

invest them ina. checking accounts.b. corporate bonds.c. NOW accounts.d. CDs.

2. Peter Udal just transferred $1,300 to a NOW accountthat offers an interest rate of 2.5 percent. Over oneyear, Peter will earn interest ofa. $39.00.b. $25.00.c. $32.50.d. none of the above

IN-TEXT STUDY GUIDE

Liabilities and Net Worth

Current Liabilities

Credit card balance $2,000

Total current liabilities $2,000

Long-Term Liabilities

Mortgage $100,000

Car loan 0

Total long-term liabilities $100,000

Total Liabilities $102,000

Net Worth $42,000

1. Based on the cash flow statement and personalbalance sheet, do the Sampsons have adequateliquidity to cover their recurring cash flows andplanned monthly savings in the long run? If not,what level of savings should they maintain forliquidity purposes?

2. Advise the Sampsons on money market invest-ments they should consider to provide themwith adequate liquidity.

study_guide182.html

IN-TEXT STUDY GUIDE 183

3. You just placed $3,200 in a one-month (31-day) CDthat offers an annualized interest rate of 5.7 percent.When the CD matures, you will receive _________ ininterest.a. $15.49b. $182.40c. $14.52d. $45.48

4. When the U.S. government wants to spend moremoney than it receives in taxes, it can obtain addi-tional funds by __________ Treasury securities.a. buyingb. sellingc. buying or sellingd. none of the above

5. ______________ is the risk that a borrower will notrepay on a timely basis.a. Credit (default) riskb. Interest rate riskc. Liquidity riskd. None of the above

6. Which of the following money market investments isprobably the least liquid?a. checking accountb. NOW accountc. money market fundsd. CDs

7. Treasury bills are purchased at a(n) ____________ parvalue.a. premium relative tob. discount relative toc. amount equal tod. none of the above

8. Walter Lemmon just paid $9,500 to purchase a one-year Treasury bill with a par value of $10,000. Thereturn on Walter’s T-bill will bea. 5.26 percent.b. 5.00 percent.c. 10.00 percent.d. none of the above

The following information refers to questions 9 and 10.

You just paid $9,650 to purchase a Treasury bill with a parvalue of $10,000 and a maturity of 182 days.

9. The annualized return on the T-bill isa. 3.63 percent.b. 7.02 percent.c. 7.27 percent.d. 3.50 percent.

10. If you hold the T-bill for 90 days and then sell it in thesecondary market for $9,870, your annualized return isa. 7.02 percent.b. 7.27 percent.c. 4.57 percent.d. 9.25 percent.

11. Short-term debt instruments issued by large corpora-tions are calleda. money market deposit accounts (MMDAs).b. commercial paper.c. money market funds (MMFs).d. CDs.

12. Which of the following is the least liquid?a. checking accountb. corporate bondsc. NOW accountd. money market fund

13. ______________ is the potential loss that could occuras a result of converting an investment to cash.a. Credit (default) riskb. Interest rate riskc. Liquidity riskd. None of the above

14. In general, money market securities that have__________ maturities have ________ interest raterisk.a. longer; lessb. shorter; morec. shorter; lessd. Answers (a) and (b) are correct.

15. Generally, yields are __________ for securities thatare exposed to __________ liquidity risk.a. higher; moreb. higher; lessc. lower; mored. none of the above

The following information refers to questions 16 and 17.

You just paid $9,875 to purchase a Treasury bill with a parvalue of $10,000 and a maturity of 91 days.

16. The annualized return on the T-bill isa. 1.25 percent.b. 4.95 percent.c. 1.27 percent.d. 5.08 percent.

17. Assuming you hold the T-bill for 45 days and then sellit in the secondary market for $9,950, your annual-ized return isa. 6.16 percent.b. 6.08 percent.c. 7.50 percent.d. 7.59 percent.


18._____________ is not a money market investment.a. A checking accountb. A Treasury billc. A common stockd. A money market fund

19. A _________________ offered by a depository institu-tion specifies a minimum amount that must beinvested, a maturity date on which the depositmatures, and an annualized interest rate.a. NOW accountb. certificate of depositc. savings accountd. money market deposit account

20. If you want to cash in a CD without being charged byyour bank, you cana. cash it in two months before maturity.b. wait until it matures.c. write checks against the CD account.d. none of the above

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