Money Markets, Certificates of Deposit and Savings Account
Banking and investment options have widened in scope and services across the globe providing the customers with multiple choices and products that are more appropriate for their needs and requirements. The paper analyses some of the banking and investment options available to the investors today that provide them with distinct benefits. Money markets have assumed great significance in today’s economies owing to their adaptability to all kinds of investment needs. Certificates of deposit provide a higher rate of interest that makes it an attractive investment options.
But despite the growing abundance of such products in the financial markets savings accounts continue to retain the consumer interest. This is largely attributed to the sense of security and reliability that this service provides to its customers. The paper highlights the distinctive features of these three financial instruments and their relative applications and benefits that it provides to its customers. Introduction Financial markets are rapidly growing more complex with the years.
The globalization of markets and technology improvements have led to faster access to information, wider reach of markets, and increasing interconnectivity leading to removal of geographical boundaries. These changes have influenced the financial markets across the globe tremendously. Banks and financial institutions have witnessed
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The investors today face varied alternatives in the form of short term debt instruments like money markets, mutual funds, treasury bills, certificate of deposits that enable the investors to reap attractive returns within a shorter time span. The discussion provides a comparative analysis of money markets, certificate of deposits and savings account in terms of their distinctive features, investment options, benefits and limitations. Money Markets – What are they? “The money market is a wholesale market for buying and selling of money” (Reuters, 2008).
The money market differs from the fixed income or bond market that trades in long term debt instruments. The trading in the money market takes place through various short term debt instruments that include loans and deposits maturing within a year’s period. These instruments are issued by government agencies, financial institutions and corporations. Hence, money markets are wholesale financial markets where financial institutions, banks, and states raise capital through loans or issue of debt securities.
Economies across the globe have devised banking systems and financial institutions to allow the movement of funds. These markets exist to facilitate the flow of funds from savers or lenders to borrowers or investors. Financial assets that are traded in the money markets include US treasury bills, commercial paper, medium term notes, bankers’ acceptances, federal agency discount paper, certificates of deposit, repurchase agreements, floating rate agreements, and federal funds (Fabozzi et al. , 2002). Money market securities are traded in high denominations and have low risk assumption for investors.
How to invest in money markets The need for short term loans and short term deposits should ideally be handled by the banks. Banks do provide such services; however, since they are heavily regulated the cost is higher. Money markets offer to meet the short term cash requirements of the market participants. Institutions and corporate entities can borrow funds if they are facing credit crunch or need to finance their business venture. In case these institutions or enterprises have surplus funds, they can be deposited in these money markets.
The term of deposit ranges from one night to one year. Retail investors can access the money markets through money market mutual funds or money market accounts that invest in money market instruments. These funds are highly popular among business enterprises since they provide easy accessibility to finance for a short term period. The following graph illustrates the percentage of US businesses’ short term assets managed by the money market funds during the period 1993 to 2007. (Source: Investment Company Institute, 2008)
“Money market funds leverage the combined assets of all the investors in the fund and are actively managed by a highly experienced fund manager” (Barclays, 2009). The fund manager is responsible for manipulating the funds collected to achieve high returns. For this purpose he needs to identify financial markets that offer high interest rates, decide when the interest rates will change and assess the risks involved in different investment alternatives. “Money market funds tend to work best when they have scale and diversified client base.
They also provide a good means of credit diversification, because they’re limited to investing no more than 10 percent of their funds with any one institution” (Barclays, 2009). Advantages and Disadvantages of Money Markets Money markets play an important role in economies since they provide organizations and institutions to lend, invest or borrow cash in the short term to meet their requirements. Financial institutions also specialize in “money market transactions, buying and selling money market instruments or accepting short term cash deposits and re-investing the funds in short term instruments” (Coyle, 2001).
Money markets provide the commercial banking system with the alternative to borrow the amount they require or lend the surplus amount they may have to the participants in the money market. Banks also make transactions in money market instruments such as bills or Certificate of Deposits to invest surplus funds or sell their holdings to raise funds. Government agencies make use of these money markets to influence the level of interest in their economies. This is primarily because the interest rates in money markets influence the interest rates in banking sector.
Investing in money market funds provide relief from tax burdens. However, money markets are not insured by the Federal Deposit Insurance Corporation (FDIC) in United States. The short term interest gained by the money market funds does not have much impact meeting inflationary pressures. Moreover, if the short term interest rates go down the overall returns on the invested money in this sector also goes down. Among other limitations of the money markets is the high amount of cash involved in transaction. Certificate of Deposit (CD) – What are they? “A certificate of deposit is a promissory note issued by the bank.
It is a time deposit that restricts holders from withdrawing funds on demand” (Investopedia, 2009). CDs are hence a special kind of deposit account that offers higher interest rate than a normal savings account. This kind of account is time bound and the holder is discouraged from withdrawing money from this account within the specified time frame. A withdrawal of money can add penalties to the interest rate that is payable on the net deposits. How to invest in CDs CDs can purchased for a fixed amount for fixed period of time that ranges from few weeks to five years or more.
The bank issuing the CD pays interest on the amount at regular intervals. At the end of the deposit period the holder receives the principal amount and the accrued interest during that period. The CDs are issued generally by the banks but there are many financial institutions and brokers who offer CDs. These deposits earned a fixed rate of interest till their maturity period but now with changing market conditions banks are offering variable rate CDs, long term CDs and some deposits that come with other special features. The minimum deposit amount for CDs is US$ 500.
The amount of interest earned by the investor is directly proportional to the time frame of deposit. The amount of interest earned on a CD also depends on the current interest rate, market conditions, how much money is invested and the banking institution chosen from which to buy the deposit. Advantages and disadvantages of CDs Investors often prefer to invest in low risk and high gains options and CDs specifically provide such benefits. These deposit instruments provide an attractive investment option for short term period.
One of the primary benefits of the CDs is that the investor knows exactly how much money he is going to earn from the investment and this can help him decide the time frame or amount to be invested depending on his requirements. Moreover, the Federal Deposit Insurance Corporation of US guarantees investments up to US$ 100,000. This makes the CDs more safer and viable alternative for investors. However, the interest earned by CDs may be higher than the saving accounts, but it is far lower compared to some other investment options and financial products available in the market such as stocks and mutual funds.
Besides, the money invested in CDs is stuck for a fixed period during which the investor cannot withdraw the amount without getting penalized for it. Any alternative use of the capital invested in such deposit schemes is not available. Savings Account – What are they? A savings account is one of the most widely used savings options by millions of people across the globe. Opening a savings account with a bank provides the customers with a safe and easy way of saving money.
This kind of account allows the users to deposit cash and withdraw cash at any point of time. Depending on the amount of balance held in the account the bank pays interest to the customer at regular intervals. The interest amount is calculated on the quarterly average or available balance during the period. Each bank pays a different rate of interest on savings account and they also have a specified minimum balance requirement. The customer needs to maintain the minimum balance in his account otherwise the bank charges penalties.
However, this balance is nominal and based on his nature of cash transactions the customer can decide to open a savings account. The banks levy charges for transactions made on the savings account. These charges or service fee of the banks vary from one bank to the other and depends on the type of transaction involved. How to invest in savings account The customer can approach any bank to open a savings account. The bank guides him through the process of account opening that includes filling in personal and professional details, proof of identity and residential address.
Once the account is activated the customer is provided with his cheque book, debit card, Internet access details and phone banking details. The holder of the savings account is provided with cheque book facility to enable withdrawal of money or payment of dues through the account. The savings account is a highly individual form of deposit instrument and acts as a cash reserve to be used for daily transactions and surplus fund deposit. The bank provides the customers with debit cards that enable the consumer to withdraw cash or make payments at stores using the card.
The amount is debited from the account balance. The savings account provides the user with the convenience to withdraw money or deposit funds without any problems. The customer should look for the interest rate provided by the different banks and the minimum balance requirements before opening an account. Many banks offer competitively higher rates of interest and lower balance requirements. Advantages and disadvantages of savings accounts Savings accounts offer distinctive advantages over any other form of financial instruments available in the market.
The primary reason why people put their money in the savings account is the security that this account provides to the customers. Money is safe in the banks and moreover these accounts are insured by the Federal Deposit Insurance Corporation in US. Moreover, savings accounts are more liquid in comparison to other forms of deposit instruments available in the market. Savings accounts are charged with minimum balance fee and transaction fee that is based on the nature of transactions made. The holder of the account has to maintain a minimum balance to avoid penalties charged by the bank.
The money held in savings account can be put to better use by investing in other financial products available that offer attractive rates of interest. Short term debt instruments in the money market are more promising to the investors in terms of capital gains. Conclusion Investing in the appropriate scheme that suits an investor’s requirements can be a challenging task given the complexity in terms of varying interest rates, liquidity benefits, and risk assessment. Money markets provide low risk and higher interest rates than savings account while facilitating easy access to funds just like saving accounts.
However, there are few individuals who prefer to invest in money markets owing to lack of adequate information on the how the money markets operate or what kinds of market forces have an impact on the interest rates. Savings accounts offer its customers with a sense of security and easy accessibility to funds but the rates of interest offered is comparatively low. Certificates of deposit offer high rates of interest but is restricted by time period that ties up the cash for the specified time. CDs are good investment options for shorter period of time and if the investor does not require the money urgently during that period.
Similarly money markets are good investment options for medium term investment while savings account for smaller denomination of funds that is used for daily transactions and accumulated to be invested in other attractive investment options. References: 1. Coyle, Brian. 2001. Money Markets. Illustrated edition. Learners professional publishing. 2. Stooker, Richard. 2008. What are the disadvantages of Money Market Mutual Funds. http://www. incomeinvesthome. com/fixed/mma/disadvantages. htm 3. Reuters. 2009. Money Market. http://about. reuters. com/productinfo/s/money_market/ 4. Fabozzi, Frank J. , Mann, Steven V.
, Choudhry, Moorad. 2002. The global money markets. 1st edition. John Wiley and Sons. 5. Investment Company Institute. 2008. Recent mutual fund trends. http://www. icifactbook. org/fb_sec2. html 6. Investopedia. 2009. Certificate of Deposit – CD. http://www. investopedia. com/terms/c/certificateofdeposit. asp 7. US Securities and Exchange Commission. High yield CDs – protect your money by checking the fine print. http://www. sec. gov/investor/pubs/certific. htm 8. Barclays. 2009. Money market funds. http://www. barclayswealth. com/institutions-intermediaries/products-services/traditional-funds/liquidity-cash-funds. htm