Liquid foreign currencies (US dollar, Japanese yen)
Certificates of deposit (CDs)
Close to expiration bonds
The types of near money used will depend on the analysis and situation.
Money vs. Near Money
The difference between “money” and “near money” is an important distinction. Money includes physical cash and bank checking accounts that can be used as a medium for exchange and exchanged immediately. Near money, although highly liquid, will take time to convert to cash. Therefore, the “nearness” of money refers to how much time it will take to convert it into cash.
Uses of Near Money
Near money is used to determine the liquidity of certain financial assets, and is used in many fields, including:
In economics, near money is a narrowly defined component of the money supply and is used to help determine the actual money supply of the economy. Near moneys are a part of the classification of assets as either M1, M2, and M3.
M1 accounts for money in circulation (physical money, checking accounts)
M2 includes components in M1 and near money
M3 includes components in M2 and other slightly less liquid assets
Measuring the money supply level helps economists and central governments to assess the macroenvironment of an economy and influence their monetary policy and fiscal policy decisions since the growth of money supply affects price levels, inflation, and the business cycle. Furthermore, the money supply is correlated with interest rates, and both are heavily impacted by quantitative easing policies enacted by various countries.
In wealth management, near money is useful when optimizing portfolios for individual investors based on their risk tolerance levels. Investors with a low ability or low willingness to take risks will allocate a greater proportion of their portfolio to highly liquid assets, such as near money.
Individuals with a high requirement for liquidity will hold various near money assets, such as high-yield savings accounts, money market funds, and Treasury bills. All of which yields approximately the risk-free rate. The risk-free rate is an appropriate compensation since there is very little to no default risk, the holding period is usually short, and liquidity is high.
An individual may need high liquidity for several reasons. For example, if they are going to retire soon or are needing a large amount of money to put a child through post-secondary education etc.
Furthermore, individuals may simply not be willing to bear any risk and do not want to see their capital decrease with market swings. The value of near money remains the same in periods of both economic expansions and recessions because of the safety and liquidity of the assets. In such situations, near money is an appropriate use of funds since investors can be ensured safety and can receive at least the risk-free rate as compensation.
In corporate treasury, near money is very useful when optimizing cash management for treasury departments of companies and other organizations. On the balance sheet, near money shows up in the liquidity analysis of a company within the cash and cash equivalents balance. It is taken into consideration when analyzing the quick (acid-test) ratio and current ratio of an organization.
The quick ratio looks at assets with short nearness, such as cash, cash equivalents, marketable securities, and accounts receivable. Whereas, the current ratio looks at assets with slightly longer nearness, including assets such as inventories that can be converted to cash over a longer period of time. Both ratios contrast the amount of assets with the amount of current liabilities to view and compare how liquid a company is.
Corporate treasury departments need to optimize their working capital, which involves monitoring a company’s incoming cash and outgoing cash, as well as the current cash balance. Treasury departments determine the amount of cash needed to meet future financial obligations and will optimize the cash balance to do so.
Excess cash can be used to make other investments or can be returned to shareholders. Cash on hand will be invested in near money assets to ensure high liquidity for when the funds are needed.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: