(This post is a part of the series on Basics of Finance and Investing.)

A money market, or “cash”, is a low-risk, short-term, liquid, debt type security. Reading from left to right, the italicized words mean - the risk of losing the principal (money you paid for the security) is low, it matures typically in a year or less, you can sell it quick, and corporations (and the government) issue these securities to borrow funds. Because of the low risk and fixed returns, a money market is an example of a fixed-income security. Following are the three major types of money markets.

Treasury bill

“T-bill” or just “bill” for short, these are securities that the US government sells to borrow fund. They are issued weekly at a minimum denomination of $1000 for 4-week, 13-week and 26-week maturation periods. You can either buy them directly from Treasury, or at a secondary market from a government securities dealer. Because they are backed by the government itself, there is almost no risk.

The way this works is that you buy T-bills at a discount from the face-value, and get back the face-value price at maturity. The discounted amount is your earning over that period (this is different from periodic earnings until maturity). For example, if you pay $9800 for a $10000 T-bill that has a 13-week maturity, you get $10000 back after 13 weeks, and therefore earn a 2.04%(=200×100/9800) interest over this period.

Certificate of Deposit

A certificate of deposit, or “CD”, is a debt instrument issued by banks. Your principal is locked for a fixed time period, which can be a few months to a few years. You get both the accrued interests and your principal back at maturity, and cannot withdraw any money until then. In this sense, a CD is different from a bank savings account (another difference is that the interest paid on a CD is usually higher than what you can get from a savings account). Bank CDs up to $100,000 are insured with FDIC, and so your investment is safe.

Commercial paper

Commercial papers are short-term debt instruments issued by large corporations to finance their businesses. They are not secure unlike bank deposits, and therefore only firms with high credit ratings can find investors without having to offer large discounts. Maturity of a commercial paper ranges up to 270 days (9 months); longer maturities require approval from SEC. Denominations are in multiples of $100,000, which makes these securities inaccessible to small investors (they can invest indirectly via money market mutual funds, which we will discuss in a later post).

Besides these three common types, other money markets are bankers’ acceptance, eurodollar, and repos.

Next we look at a Bond.

(This post is a part of the series on Basics of Finance and Investing.)

Merriam-Webster Online Dictionary defines the word security as “the state of being secure”. Then further down, “an instrument of investment in the form of a document (as a stock certificate or bond) providing evidence of its ownership”. These two definitions are not unrelated. A security is an investment instrument that is supposed to secure your financial future.

There are two broad classes of securities, depending on the nature of returns on their investment and the risk involved.

Fixed-income security

A fixed-income security, from its name, pays a fixed periodic return until maturity, when the principal (the amount originally paid to buy the security) is also returned. Fixed-income securities involve very low risk of devaluation/loss of the invested principal. An example is a Money Market instrument such as a Treasury bill.

Variable-income security

A variable-income security, by contrast, is one whose returns as well as the value of the principal vary based on underlying conditions, such as changes in the short-term interest rates. Because the principal itself can go up and down, investing in variable-income securities usually involves considerable risk. Examples include company stocks.

Why should I invest in high-risk assets?

A sensible question. Why? Because it is a fundamental fact of investing that taking more risk will reward you with higher long-term growth of your invested asset. For example, buying a 5-year CD (Certificate of Deposit) - a fixed-income security - at 5% annual interest will guarantee you a risk-free periodic return plus the principal after 5 years. On the other hand, investing in the S&P stock Index fund - a variable-income security with large short-term fluctuations - involves high risk, but your asset would grow at over 10% during most 5-year intervals.

The key phrase here is “long-term” (italicized above). If you want your money quickly, you are better off with low-risk fixed-income type investing. On the other hand, if you can wait several years (the more the better), investing with variable-income securities will smooth out the short-term fluctuations, and get you much higher returns at the end.

We continue with Money Market in the next post.

(This post is a part of the series on Basics of Finance and Investing.)

In simple terms, a market is where buyers and sellers meet to exchange goods for money. This basic concept still works in the sophisticated world of finance, except that there are now four organizational levels depending on the nature and volume of transactions.

Direct search market

This is where buyers and sellers seek each other out. If you want to sell your TV, you put out an ad in the local newspaper or on Internet (such as craigslist). A buyer looking for a similar TV contacts you from this ad, and you two carry out the trade quick and easy. Because of the intermittency and small scale of such transactions, there is no earning opportunity for an intermediary by offering specialized services to the buyer and/or seller.

Brokered market

This is the next level in market organization. Whenever a good is traded in high volume, an intermediary evolves to offer its services for a fee. For example, in real estate market both the seller and buyer of homes often enroll a real estate broker to do the necessary searches.

Another example, relevant to this series, is a primary market, where new issues of company securities (stocks and bonds) are sold to the public. In such a market, the investment bankers act as brokers between the issuing firm and investors.

Dealer market

A dealer market arises when the trading volume for a good increases substantially. Dealers purchase the item for their own inventory, and then sell it to buyers. The “bid-asked spread” - difference between the price a dealer pays to buy the good (bid) and sells it for (ask) - is his profit.

An over-the-counter securities market, where already issued securities are traded between investors via the dealer, is an example of a dealer market. Because no new security is issued, this is also an example of a secondary market.

Auction market

This is the highest level of market organization. In an auction market, buyers and sellers get together under one roof. Both parties have several trading choices available to them in the same place, which eliminates the need for a dealer inventory and saves the bid-asked spread. A well-known example is the New York Stock Exchange (NYSE), where investors trade securities among themselves. So, stock exchanges are also secondary markets.

Because such auctions occur continuously, the corporations must carry out frequent and high volume trading to meet the cost of running the exchange. For this reason, NYSE and other such organizations have set up listing requirements for the firms to participate in them.

How often did you wish your teenager kid were a little more careful with pocket money? Or your parents, who are about to begin their retired life? Or even yourself - maybe fewer of those costly college parties could have helped you pay off your student loan sooner?

Many, including me, believe it is no longer a question of if we need a money management course, but when. A basic knowledge in personal finance and investing is a must for everyone of us. (The only time you may not care about managing money is if your current wealth outlives you.)

But should we teach this course to our school kids? Or in college maybe, if it is possible to squeeze this in an already over-stuffed curriculum? Surely sooner than later, but how soon? And, who should do the teaching? Academia, or firms that specialize in finance?

Consumerism Commentary shares some interesting thoughts on these issues. I agree with him that corporations such as Citi sponsoring these events is a good thing. Businesses certainly have vested interests, but maybe their interest is our interest too. A money-savvy client can better utilize the enormous resources that such financial corporations have to offer. (I still remember the first time I looked up Vanguard’s list of mutual funds - it was scary.)

(This post is a part of the series on Basics of Finance and Investing.)

You and I, as members of the household sector, want to invest our money, whereas the business sector wants to raise money to pay for real assets. Such supply and demand requirements create an atmosphere of synergistic interactions between these two sectors.

Financial intermediary - (1) Banks

The problem is that the size of a typical household investment is too small to meet the need of large businesses. I cannot lend Microsoft enough money to make a whiff of a difference to its finances. But, if funds are pooled together from a large number of households, businesses can then borrow from this substantial pool.

Thus, a financial intermediary can make a profit from the difference between the interest it charges the businesses (borrower) and the interest it pays the households (lender). This is exactly what a bank does. The mismatch of scales between the interests of household and business sectors allow banks to earn by providing a service that indirectly brings them together.

(2) Investment companies

Besides borrowing from banks, businesses also sell stocks and bonds directly to the investors. Here again, the smallness of household assets becomes a problem. An investor cannot often afford the substantial brokerage and trading costs to own a large number of securities from different companies (that is needed to adequately diversify his portfolio).

Investment companies, such as Vanguard, Fidelity and T. Rowe Price, have evolved from these mutual needs to sell and buy company securities. Like banks, they pull together funds from small investors and purchase a variety of securities. Each investor pays for shares of this composite holding, known as a mutual fund, which provides the necessary diversification. Part of the payment goes to the fund operators as management fees.

Investment banks

Unlike the banks and investment companies that serve as intermediaries between investors and businesses, investment banks provide services only to the businesses. Because firms issue stocks and bonds to raise funds, investment bankers such as Merrill Lynch, Goldman Sachs and Smith Barney advice them, for a fee, on the prices they should charge for these securities, prevailing market conditions, appropriate interest rates and so on. They also act as brokers in seeking out investors when new securities are issued.