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Characteristics, Uses and Taxation of Investments - Cash and Equivalents


These are characterized by liquidity, safety of principal and inflation risk. Each one has unique features which are discussed below.


A. Certificates of deposit (CD): A CD is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Unlike other investments, CDs feature federal deposit insurance up to $100,000. Because federal deposit insurance is limited to a total aggregate amount of $100,000 for each depositor in each bank or thrift institution, it is very important that you know which bank or thrift issued your CD. CDs work in this way: When you purchase a CD, you invest a fixed sum of money for a fixed period of time - six months, one year, five years, or more - and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your CD, you receive the money you originally invested along with any accrued interest. But if you redeem your CD before it matures, you may have to pay an "early withdrawal" penalty or forfeit a portion of the interest you earned. The issuing bank may choose to waive the penalty. CDs have become more complex over time. Investors may now choose among variable rate CDs, long-term CDs and CDs with other special features. Some long-term, high-yield CDs have "call" features, meaning that the issuing bank may choose to terminate - or call - the CD after only one year or some other fixed period of time. Only the issuing bank may call a CD, not the investor. For example, a bank might decide to call its high-yield CDs if interest rates fall, subjecting existing investors to reinvestment risk. But if you have invested in a long-term CD and interest rates subsequently rise, you will be locked in at the lower rate. Investors need to research and understand the various CD provisions in order that they choose the CD most appropriate for their circumstances. CDs are useful to obtain a competitive yield with relatively easy access to funds.

Look Out!
There may be a question on the extent of FDIC coverage with a fact patter of a couple holding several accounts.

B. Money Market Funds: A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. Such funds have relatively few risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a "money market deposit account" at a bank, money market funds are not federally insured. Money market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. They attempt to keep their net asset value (NAV) at a constant $1.00 per shareonly the dividend yield goes up and down. But a money market's per share NAV may fall below $1.00 if the investments perform poorly. While investor losses in money market funds have been rare, they are possible. Like other short-term paper, such funds are subject to inflation risk. These types of mutual funds provide liquidity without typing up investor's funds. Investors often use money market mutual funds to park cash while awaiting the right investment opportunity.

Cash and Equivalents (Contd.)

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