Cash and equivalents
Also written Cash equivalents
The asset class investors use to park money they may need at very short notice — near-zero volatility, near-zero risk of loss to principal, and ready availability.
In plain language
Some money should never be at risk. Money needed next week, or next month, has no business sitting in shares that could fall 10% overnight.
Cash and equivalents are the parking spot for that kind of money — savings accounts, liquid funds and similar instruments that barely move in value and can be turned into spendable cash almost immediately.
How it works
The workbook places cash and equivalents at one end of the investment-horizon spectrum: investors who expect to hold an investment for very short periods consider cash and equivalents, because these instruments have little or no volatility in returns, letting the investor use the funds when required without any risk of loss to the principal invested. Bonds suit intermediate and long holding periods; equity and other volatile asset classes need a long horizon.
In a retiree's bucket strategy, cash and equivalents specifically form the first year of Bucket 1 — the segment of the portfolio meant to be spent almost immediately, ahead of bank deposits maturing in years two through five.
A worked example
A retiree needs Rs 6 lakh over the coming year to cover living expenses. Rather than holding it in equity or even a fixed deposit that locks the money away, the adviser places it in cash and equivalents — a savings account and a liquid mutual fund. There is effectively no volatility: whatever amount is placed is what will be available when the bill arrives, month after month, with no risk of a market fall eating into the sum set aside for immediate spending.
Why NISM asks about it
Chapter 2, section 2.7 (Matching Investor Needs to Asset Class Features), places cash and equivalents at the short end of the investment-horizon spectrum. It reappears as the funding source for the first year of Bucket 1 in the Chapter 7 bucket strategy, so expect it to be tested both as a standalone asset-class concept and inside a bucket-strategy scenario.
Common exam traps
- Cash and equivalents protect principal but do not grow it in real terms — over time, inflation still erodes the purchasing power of money parked here, even though its rupee value does not fall.
- Do not confuse cash and equivalents with fixed deposits: the workbook treats FDs as a step up in horizon (bucket 1, years two to five), while cash and equivalents are for money needed almost immediately (year one).
Check yourself
1.An investor needs to park money for three months before paying a house down payment. Which asset class is appropriate and why?
- a)Equity, because a long horizon allows appreciation
- b)Cash and equivalents, because these have little or no volatility in returns and the funds can be used when required without any risk of loss to the principal
- c)Long duration debt funds, because they offer the highest yield among debt options
- d)Gold, because it acts as a hedge against inflation
Show the answer
Answer: (b) Cash and equivalents, because these have little or no volatility in returns and the funds can be used when required without any risk of loss to the principal
For very short periods the workbook prescribes cash and equivalents to park their money, because these investments have little or no volatility in returns, and investors will be able to use the funds when required without any risk of loss to the principal.
The objective here is preserving the absolute value of the capital invested and high liquidity, rather than earning returns. Low return is the design, not a defect.
Equity needs a long horizon to benefit from economic cycles. Long duration debt carries the greatest interest rate risk — a rate rise three months before the payment would be costly. Gold gives no periodic income and its price could fall over three months.
The governing principle: as goals come closer and the investment horizon shrinks, investors should shift funds from the volatile asset class to one with steady returns.
Where this is taught
Free preparation for NISM Series XVIIRelated terms
- Liquidity riskThe risk of being unable to get out of a position at or near the quoted price — because the contract is bilateral, because the order book is thin, or because volumes dry up near expiry.
- Asset allocationThe decision on how to distribute a client's wealth across asset classes — the first decision in building a portfolio, and the one that explains most of what the portfolio then does.
- Bucket strategyA retirement income plan that splits the corpus into three buckets by time horizon — near-term cash, medium-term income assets, long-term growth — so a downturn never forces a sale of risky assets for near-term spending.
- Profit booking in the bucketsA maintenance rule inside the bucket strategy: set a target return on the riskier buckets, and whenever it is beaten, move the excess down into a safer bucket rather than letting it ride.
- Medical corpusA pool set aside for the health costs insurance does not pay — medicines, consultations, tests and long-term care — which the workbook says must hold at least three years of such expenses in liquid assets at retirement.
- Base Minimum CapitalThe deposit every trading member must keep with the exchange purely to meet contingencies — it earns the member no trading exposure at all, and its size depends on what kind of trading the member does.