Should Households Establish Emergency Funds?

Written By: Charles B. Hatcher

This paper uses both an individual cost-benefit model and a deterministic simulation to investigate whether or not households should sacrifice higher rates of return in more liquid and less volatile investments in order to be prepared for a financial emergency. The cost of having an emergency fund is the difference between the rate of return in an illiquid, volatile investment and the rate of return in an emergency fund. The benefits of an emergency fund are the borrowing costs avoided in an emergency. With reasonable assumptions about borrowing and lending rates, emergencies would have to occur very frequently for an emergency fund to be optimal. Key words: Emergency funds, Financial ratios, Liquidity, Risk

Comments are closed.