4.1 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

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.

Issuer: U.S. Treasury

Maturities: 4, 6, 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.

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.

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:

1. The goods being shipped

2. The importing company

3. The accepting bank's guarantee

Repurchase Agreements (Repos)

A repo is a short-term loan using securities as collateral.

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:

1. Dealer sells $10 million in Treasuries to investor for $10 million

2. Agreement to repurchase tomorrow for $10,000,500

3. The $500 difference is the interest (one-day loan)

Bank Deposits

Certificates of Deposit (CDs)

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

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.

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

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:

1. T-Bills: Sold at discount, state tax exempt, shortest maturity Treasuries

2. Commercial Paper: Unsecured, corporate, max 270 days, NOT Fed-eligible

3. Banker's Acceptances: Trade financing, bank-guaranteed, Fed-eligible

4. Repos: Short-term loans collateralized by securities

5. Money Market Funds: NOT FDIC insured, target $1.00 NAV

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"