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Financial services: (251fin)

Savings and Money Market Investment Products

By

Dr Jacinta Nwachukwu

Principal Lecturer in Finance

School of Economics, Finance and Accounting

Email: [email protected]

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Something to think about

Learning outcomes

Types and characteristics of savings products

Types and characteristics of money market instruments

Types of interest rates on savings

Advantages and disadvantages of the Financial Services Compensation Scheme (FSCS)

Risk-return characteristics of different asset classes

The type and effectiveness of risk reducing strategies

The types and feasibility of online saving and investment services

Lecture outline

1. Types and characteristics of savings products

2. Types and characteristics of money market investment products

3. Factors that influence the decision to choose amongst savings and investment products

(i) Interest earned

(ii) Financial stability of the providing institution

(iii) Risk-return profile of the product

(iv) Type and flexibility of the product delivery method (e.g. online banking)

(v) The availability and cost of risk management strategies

(vi) Tax advantages

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Figure 2: UK Households with types of savings 2008/2009

Current account Post office card account Basic bank account National savings and Investment: savings account Individual Savings Account (ISA) other bank/building society accounts Stocks and shares/member of a share club Unit trusts Endowment policy: not linked to mortgage Premium Bonds National Savings Bonds Company share scheme/profit sharing Credit unions No accounts 91 7 7 4 40 48 18 4 2 22 3 3 1 3

The Main Types of UK household savings

Deposit accounts

Individual Savings Account (ISA)

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Types of UK Household Savings

Deposit accounts: There are a wide range of deposit services offered by banks in the UK.

These deposits have features designed to attract customer funds in today’s competitive market

Examples of deposit accounts include:

(1) Demand deposit services requires banks to honour immediately any withdrawals made either in person by the account holder or by a third party to be the recipient of funds withdrawn

(2) Interest bearing savings accounts give the bank the right to insist on prior notice before the customer withdraws funds.

These type of deposit are designed to attract funds from customers and businesses that wish to set aside money in anticipation of future expenditures or for financial emergencies

The majority of these savings account carry fixed maturity dates, often covering 30, 60, 90, 180 or 360 days, 5 years or more at fixed interest rates.

The longer the number of days, the normally the higher the interest rate.

Customers may be penalised for an early withdrawal without the required number of days of notice

Thus, such time deposits are not appropriate for customers who wish to save for “emergency” situation

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Individual Savings Account (ISA)

Earnings from savings and investment products in the UK are usually taxable. So since April 2008, savings in some types of products such as ISAs have been exempted from taxation.

An ISA is a special scheme or “wrapper” that allows saving or investment to be up to a specified limit each year, with no tax on interest or capital gains received. However, dividends or other share-based income are taxed at a basic rate of 10 percent.

In April 2014, a total of £15,240 a year could be invested in a “Cash ISA” or “Stock or Shares ISA”, rising to £20,000 a year in April 2017

Investment can be in a lump sum and/or in a regular or ad-hoc contributions throughout the tax year. Yearly ISA allowance expires at the end of the tax year and any unused allowance will be lost.

The different types of investment which can be held in a Stock ISA include: Individual stocks and shares, company and government bonds, unit trusts, open ended funds, exchange traded funds and investment funds.

Stock ISAs are only for those which are comfortable with the fact that the value of your investments can go both up and down and that you may get back less than you invested.

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2. Types of Money market products

Treasury Bills

Certificates of Deposit

Eurocurrency deposits

Bankers’ acceptances

Commercial papers

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Treasury Bills (T-Bills)

This is a debt obligation of a government, say the UK, that must by law mature within one year from date of issue

T-bills are sold at weekly and monthly auctions organised by the Debt Management Office (DMO) http://www.dmo.gov.uk/

T-bills are traded at a discount from their par (face) value

Thus, the total return on T-Bills consists entirely of price increases as the security approaches maturity

The advantages of T-Bills lie in their

(i) High degree of safety because they are supported by the government

(ii) High liquidity and relatively stable market prices.

(iii) High acceptability as collateral for borrowing

Key disadvantages is that:

(i) They have low rates of return

(ii) Income is taxable

(iii) They are sold in large amounts, meaning that they can only be bought through investment funds

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Certificates of Deposit (CD)

A CD is an interest-bearing receipt for the fixed-term deposit of funds in a bank.

The attractiveness of CDs and price paid depends on the credibility of the issuing bank

CDs are sold in high denominations and so are purchased through investment funds

CDs have negotiated interest rates that may fluctuate with market conditions

CDs have higher yields than on T-bills

The market for long-term CDs are limited

Income is taxable

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Eurocurrency Deposits

Eurocurrency deposits are time deposits of fixed maturity placed in bank accounts outside the originating country.

For example, Eurodollars are dollar-denominated deposits placed in bank accounts outside the United States.

Euro-sterling is sterling-denominated time deposits placed in banks outside the United Kingdom

Eurocurrency deposits are low risk

Eurocurrency deposits have higher yields than on domestic currency denominated CDs with comparable maturity

Interest rates on Eurocurrency deposits are highly volatile

Interest income is taxable

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Bankers’ Acceptances

These are promissory notes to pay the holder a designated amount of money on a specified future date

They arise from a bank’s decision to pay-off the debt of its customers who are exporting, importing or storing marketable commodities in return for a fee

The bank as the primary obligor is required to supply its name and credit standing so that the holder of acceptances will be able to obtain credit elsewhere at lower cost

Because bankers’ acceptances are of low risk, they can be traded from one investor to another before they reach maturity

A bank acceptance is a discount instrument. They are sold at a price below their face value so that the investor’s expected return comes from the prospect that the price will rise as the acceptance approaches its maturity

They are issued in large denominations. Therefore can only be bought through investment funds

Income earned by investors is taxable

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Commercial papers

Commercial papers are unsecured IOUs offered by major corporations to meet immediate needs for cash

Also, the proceeds from the sale of commercial papers may be used to purchase outstanding loans, thus giving the institutions additional funds to make new loans (in the case of financial institutions) or improve their debt ratios

These papers normally have maturities ranging from three or four months to nine months

They are sold at a discount from face value in large denominated amounts.

The investors’ expected return comes from the rise in the paper’s price as it gets closer to maturity

The riskiness and price of commercial papers depends on the creditworthiness of the issuing company

Compared with the T-Bills, the market for commercial papers are volatile and less marketable

Income earned is taxable

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3. Factors influencing choice of savings and investment products

(i) Types of interest earned

(ii) Financial stability of the providing institution

(iii) Risk-return profile of the product

(iv) Type and flexibility of product delivery (such as online banking)

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3.1. Types of interest rate earned

1. Simple versus compound interest rates

2. Annual equivalent rates (AER)

3. Nominal versus real interest rates

4. Interest yield and total return

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Simple versus compound interest rates

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Something to think about

Suppose that £1000 is deposited in a savings account for 4 years at an interest rate of 10 percent per annum.

Questions:

1. What is the total amount in the savings account at the end of the first year?

2. What is the total amount in the savings account at the end of the second year?

3. What is the total amount in the savings account at the end of the third year?

4. What is the total amount in the savings account at the end of the fourth year?

We note that:

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Simple and Compound Interest Rates

The value of the savings at the end of each time period T is known as the future value of the original (or initial) investment

Where:

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Annual equivalent rate

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Annual Equivalent Rate (AER)

The interest rate on savings products are expressed as the Annual Equivalent Rate (AER).

The AER is the annual interest rate that savers receive calculated to take account of the time when interest is actually paid and the number of compounding (for instance, daily, weekly, monthly, quarterly and annually)

The increased frequency of compounding by a constant rate raises the annual equivalent rate.

For example, suppose that an investment of £1000 at an interest rate of 10 percent payable six monthly

What is the value of the investment at the end of the year?

What about for a quarterly payment?

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Something to Think About

Suppose that a savings account offers an annual interest rate of 10 percent, with interest payable daily, weekly, monthly, quarterly

(i) Calculate the AER for each savings account using the equation below.

(ii) Calculate the end balance in the savings account at the end of the year for a £1000 initial investment

APR = Annual percentage rate

m = The number of compounding per year

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Calculating AER

Compounding period APR (%) m AER Total ending balance (£)
Daily 10 365
Weekly 10 56
Monthly 10 12
Quarterly 10 4
Annually 10 1

APR = Annual percentage rate

m = The number of compounding per year

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Nominal versus real rate of interest

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Nominal and Real Rates of Interest

The nominal interest rates is the rate required to compensate for rise in prices (i.e., inflation) expected to occur during the period of investment

This is the rate quoted by banks, building societies and other deposit institutions.

The real interest rate is the rate net of the reward for inflation

Thus, the real interest rate provides the measure of return from investing in terms of the purchasing power of the payments received.

The real interest rate is given by the expression:

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Interest yield and total return

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Interest yield and total return

Interest yield is the flow of interest payments to the investor.

This is the only source of payment on savings deposits.

For other investments, such as bonds, stocks and property, earnings come from two sources:

(i) Interest yield

=

(ii) Capital gains yield (or losses) depending on price fluctuations

=

The total return is the sum of interest rate and capital gains yield

=

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3.2. Stability of the Financial institution

The Financial Services Compensation Scheme (FSCS) 

https://www.moneyadviceservice.org.uk/en/articles/compensation-if-your-bank-or-building-society-goes-bust

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Financial Stability

Savers should take account of the financial standing of the firm offering savings and investment products

This is particularly the case if the interest rate offered is much higher than the perceived risk

For example, many savers would have lost their money when several Icelandic banks which promised them high fixed rates on bonds collapsed during the 2007/2008 financial crisis

In the UK, the authorities stepped in to provide compensation for savers when Northern Rock collapsed

In the UK, savers who deal with authorised banks and building societies have recourse to the Financial Services Compensation Scheme (FSCS) if the institution is unable to pay back

For saving products the compensation is limited to £75,000 (or £150,000 for joint accounts) per authorised firm.

So to keep their money safe, savers are advised to move any excess funds to another provider to make sure their money is protected if the institution runs into difficulties.

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3.3. Risk-return trade-off

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Figure 1: The Risk-Return Trade-off

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Expected return for taking on extra risk (i.e., risk premium)

Expected return

Risk

Expected return for delaying consumption

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T.Bill

CDs

CPs

Bonds

Stocks

Savings deposits

Higher

Lower

Higher

Lower

Eurocurrency

Demand deposits

Properties

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Something to think about

Figure 1 shows that investing in stocks makes the highest returns. Why don’t people put all of their money in equities rather than in low yield assets such as bonds and savings accounts?

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3.4. Type and flexibility of product delivery

Since the mid 2000’s, there has been a significant growth in e-banking or online banking.

The number of banks offering online savings accounts and investment services is growing faster than the traditional brick-and-mortar branch offices.

Automated teller machines (ATMs) dispensing cash and accepting deposits

Point-of-sale (POS) terminals in stores and shops to facilitate payment for goods and services

Through many of these computer-and technology-based delivery systems, customers can check account balances, move funds between accounts, pay bills, request loans and invest money any hour of the day and night.

Most electronic banking branches operate at a far lower cost than do conventional brick and-mortar branch offices

A key problem with virtual banking is the weak customer relationship and confidence

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End of lecture

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To save or to invest? That is the question

https://www.youtube.com/watch?v=WRrFIyhKr9w

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Take home assignment 1

(1). Suppose that £1000 is invested for 10 years at 5 percent per annum

(i). What is the future value of the £1000

(ii). What is the simple interest?

(iii). What is the compound interest?

(2). What would the answers be if the £1000 were invested for 45 years?

(3). What would the answers be if the £1000 were invested for 45 years at 10 percent?

(4). Explain how your initial investment has increased in value

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Take Home Assignment 2

1. Check the rate of interest on the range of savings products offered by your British bank.

Which of these products offer inflation-proof returns. Assume that the rate of inflation in the UK is currently 2.5 percent.

What are the key factors that explain the interest rate offered on the different products

2. Savers in the UK who deal with authorised banks and building societies are protected by the Financial Services Compensation Scheme (FSCS) should the providers run into difficulties.

What are the advantages and disadvantages of such deposit insurance schemes?

3. Explore the characteristics of the investment and savings products provided by your bank and explain how UK residents might use them to reduce their tax burden.

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Take home assignment 3

1. Suppose a bank deposit pays 10 percent per annum one year and 15 percent per annum the next year.

(i). Calculate the average compound rate of return on the basis of annual interest payments

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(ii). Assume that the rates in (1) are nominal interest rates and that inflation in the two years was 6 percent and 10 percent respectively. Calculate the average compound real rate of return

(iii). What would be the real end balance in the savings account at the end of the two years