Cash & Cash Equivalents
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash. They are the foundation of liquidity management and capital preservation strategies.
Characteristics of Cash Equivalents
| Feature | Description |
|---|---|
| Maturity | Typically 90 days or less (some up to 1 year) |
| Liquidity | Highest—easily converted to cash |
| Risk | Very low (principal preservation) |
| Returns | Low—trade safety for yield |
| Price Volatility | Minimal |
Money Market Instruments
Treasury Bills (T-Bills)
T-Bills are the safest money market instrument, backed by the full faith and credit of the U.S. government.
| Feature | Description |
|---|---|
| Issuer | U.S. Treasury |
| Maturities | 4, 8, 13, 17, 26, and 52 weeks |
| Minimum Investment | $100 |
| How Sold | At a discount to par value |
| Interest | No periodic payments; return is difference between purchase price and par |
| Credit Risk | None (government guaranteed) |
| Tax Treatment | Federal taxable; exempt from state and local taxes |
How T-Bill Pricing Works:
- Purchase a $10,000 T-bill at $9,800
- At maturity, receive $10,000
- Your return is $200 (the discount)
Commercial Paper
Commercial paper is short-term unsecured promissory notes issued by corporations.
| Feature | Description |
|---|---|
| Issuer | Corporations (usually large, creditworthy) |
| Maturities | 1 to 270 days (most common: 30-90 days) |
| Security | Unsecured (backed only by issuer's creditworthiness) |
| How Sold | At a discount to par value |
| Use | Working capital, short-term financing |
| Ratings | A-1/P-1 (highest quality), A-2/P-2, etc. |
| Fed Eligibility | NOT eligible for Fed trading (settles in clearing house funds) |
Why 270 Days Maximum? Securities with maturities over 270 days require SEC registration. Commercial paper stays under this limit to avoid registration costs.
Banker's Acceptances (BAs)
Banker's acceptances are time drafts that a bank has "accepted" and guaranteed to pay.
| Feature | Description |
|---|---|
| Primary Use | International trade financing |
| How Created | Importer's bank accepts (guarantees) draft drawn on it |
| Maturities | Typically 30-180 days |
| How Sold | At a discount |
| Credit | Backed by: goods, importer, and guaranteeing bank |
| Fed Eligibility | Prime BAs ARE eligible for Fed trading |
| Liquidity | Active secondary market |
Three Layers of Security:
- The goods being shipped
- The importing company
- The accepting bank's guarantee
Repurchase Agreements (Repos)
A repo is a short-term loan using securities as collateral.
| Feature | Description |
|---|---|
| Structure | Sale of securities with agreement to repurchase at higher price |
| Typical Maturity | Overnight to several weeks |
| Collateral | Usually Treasury or agency securities |
| Users | Securities dealers, banks, institutional investors |
| Reverse Repo | Same transaction from the lender's perspective |
How a Repo Works:
- Dealer sells $10 million in Treasuries to investor for $10 million
- Agreement to repurchase tomorrow for $10,000,500
- The $500 difference is the interest (one-day loan)
Bank Deposits
Certificates of Deposit (CDs)
| Feature | Description |
|---|---|
| Type | Time deposit with fixed term and rate |
| FDIC Insurance | Up to $250,000 per depositor, per bank |
| Early Withdrawal | Penalty typically applies |
| Negotiable CDs | Large denominations ($100,000+); can be traded |
| Non-Negotiable CDs | Cannot be traded; must hold to maturity or pay penalty |
Brokered CDs: Sold through brokerage firms; may offer FDIC insurance but have market risk if sold before maturity.
Demand Deposits
| Type | Features |
|---|---|
| Checking Accounts | Unlimited access; low/no interest |
| Savings Accounts | Higher interest; some access limitations |
| Money Market Deposit Accounts | Higher rates; limited check-writing |
All are FDIC insured up to $250,000.
Money Market Mutual Funds
Money market funds are mutual funds that invest in money market instruments.
| Feature | Description |
|---|---|
| NAV Target | Seek to maintain $1.00 per share |
| FDIC Insurance | NOT insured by FDIC |
| Regulation | SEC Rule 2a-7 governs |
| Liquidity | Very high—typically same-day redemption |
| Investments | T-bills, commercial paper, repos, CDs |
Types of Money Market Funds
| Type | Investments | Tax Treatment |
|---|---|---|
| Prime | Corporate commercial paper, CDs | Fully taxable |
| Government | Treasuries, agencies | State tax exempt |
| Tax-Exempt | Municipal securities | Federal tax exempt |
"Breaking the Buck": Rare event when a money market fund's NAV falls below $1.00 (last occurred in 2008 with Reserve Primary Fund).
In Practice: How Investment Advisers Apply This
Cash management for clients:
- Maintain adequate emergency reserves (3-6 months expenses) in cash equivalents
- Match vehicle to client's needs (taxable vs. tax-exempt)
- Consider state tax exemption of Treasuries for high-tax state residents
- Evaluate safety (FDIC vs. non-FDIC) based on amount
Portfolio construction:
- Use cash equivalents for short-term goals or upcoming expenses
- Park funds temporarily during market uncertainty
- Provide liquidity buffer in retirement portfolios
On the Exam
The Series 65 exam tests your understanding of:
- T-Bills: Sold at discount, state tax exempt, shortest maturity Treasuries
- Commercial Paper: Unsecured, corporate, max 270 days, NOT Fed-eligible
- Banker's Acceptances: Trade financing, bank-guaranteed, Fed-eligible
- Repos: Short-term loans collateralized by securities
- Money Market Funds: NOT FDIC insured, target $1.00 NAV
Expect 2-3 questions on cash equivalents. Common formats include identifying characteristics of specific instruments.
Key Takeaways
- Cash equivalents are short-term, liquid, low-risk, low-return investments
- T-Bills are the safest; sold at discount; state tax exempt
- Commercial paper is unsecured corporate debt; max 270 days
- Banker's acceptances finance international trade; bank-guaranteed
- Repos are collateralized short-term loans
- Money market funds are NOT FDIC insured; target $1.00 NAV
- CDs are FDIC insured up to $250,000
- Commercial paper settles in "clearing house" funds; T-Bills and prime BAs settle in "Fed funds"
Treasury bills differ from other money market instruments because they:
Commercial paper is:
Money market mutual funds:
4.2 Treasury Securities
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