What Are Cash Equivalents?
Cash equivalents are securities with solid credit quality and high liquidity. These securities are considered equivalent because they can be quickly converted into actual cash.
Types of Cash Equivalents
Cash equivalent securities have a low-risk, low-return profile, short maturities, and high liquidity. Examples include the following:
Treasury Bills
Treasury bills are securities issued by the U.S. Department of the Treasury that mature in one year or less:
Treasury bill purchases lend the government money, which is repaid upon maturity.
The securities are sold at a discount and redeemed at face value.
A Treasury bill’s minimum purchase amount is $100.
The maximum purchase amount for a non-competitive bid is $10 million.
The maximum purchase amount for a competitive bid is 35% of the offering amount.
A Treasury bill’s yield is the difference between the purchase price and the value at redemption.
Commercial Paper
Commercial paper is short-term, unsecured debt that large companies use to fund short-term liabilities such as payroll. Businesses issue commercial paper at a discount and promise to pay the face value on the maturity date, which ranges from one to 270 days.
Marketable Securities
Marketable securities are highly liquid financial assets traded on public exchanges, such as the New York Stock Exchange, and secondary markets, such as private or over-the-counter deals. Marketable securities typically mature in one year or less, and their rates have a minimal impact on prices.
Examples of marketable securities include:
Treasury bills
Certificates of deposit (CDs)
Bankers' acceptances
Commercial paper
Exchange-traded funds (ETFs)
Money Market Funds
Money market funds are mutual funds that invest in cash and cash equivalents:
A money market fund’s share price is $1 per share.
The funds are highly liquid and have excellent credit quality.
A money market fund’s stability helps investors efficiently and effectively manage their money.
Short-Term Government Bonds
Short-term government bonds are highly liquid, actively traded securities. The government issues the bonds to fund government projects. Investors should consider political, interest rate, and inflation risks before purchasing government bonds.
Certificate of Deposit
A certificate of deposit (CD) is a savings account that cannot be accessed for a specific time, typically one month to five years:
The financial institution pays the individual a fixed interest rate for the use of their funds.
The individual might be able to pay a fee or interest penalty to break the contract and access their money.
A CD purchased through a federally insured bank is insured up to $250,000.
Banker's Acceptance
A banker’s acceptance is a payment guaranteed by a bank. The short-term issuance is often used to facilitate low-risk transactions.
Features of Cash Equivalents
Most cash equivalents have the same characteristics, including:
Liquidity: Cash equivalents must trade in liquid markets and be easily converted to cash. For instance, many CDs allow early redemption by paying a fee or relinquishing part of the interest.
Short-term investment: Because cash equivalents must be easily converted to cash, the term is often very short.
Low risk and volatility: Cash equivalents are meant to be an efficient, low-risk investment for cash on hand.
Unrestricted access: An investor should be able to convert their cash equivalent to cash on demand.
Uses of Cash Equivalents
Individuals might invest in cash equivalents for the following uses:
Portfolio risk reduction: Balancing volatile assets, such as stocks, with stable investments to lower portfolio risk.
Emergency funds: Providing instant access to cash for unexpected expenses, such as car or home repairs or medical bills, without risking the principal
Short-term savings goals: Securing funds needed within a short timeframe, such as for a down payment on a home.
Capital for opportunities: Maintaining available funds to purchase stocks or other assets during market downturns.
Advantages of Cash Equivalents
Investing in cash equivalents offers the following advantages:
More efficient use of capital: Cash equivalents often pay more interest than a basic bank account.
Fast access: Short-term investments are highly liquid, providing cash when needed.
Fixed interest rates: Individuals know the amount of income to expect over a set time.
Disadvantages of Cash Equivalents
Investing in cash equivalents can have the following advantages:
Lower returns: Cash equivalents typically earn less interest than longer-term investments.
Risks: If the issuer defaults, investors might not receive the agreed-upon return.
Fees or fines: Early redemptions might incur fees or fines, reducing the return on investment.
*This information is for educational purposes only.
Do you invest in cash equivalents, or do you plan to? Let me know in the comments!
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