Personal Finance, 6th Edition, Chapter 6 PDF

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

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 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 Fund Average Maturity 7-Day Yield Assets (millions of $) Star Fund 43 3.28% 496 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 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 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  Optimal Allocation of Money Market Investments Copyright © 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved