Management of Marketable Securities

Firms will maintain levels of marketable securities to ensure that they are able to

quickly replenish cash balances and to obtain higher returns than is possible by

maintaining cash. Firms will hold securities with very little risk for their immediate

cash needs. Highly liquid debt instruments such as commercial paper (short-term

marketable promissory notes issued by financial institutions and other

corporations), bankers' acceptances (drafts issued and accepted by banks often used

in international trade) and various government securities such as Treasury Bills and

agency notes are frequently maintained in marketable security accounts. Other

highly liquid instruments such as money market funds, negotiable certificates of

deposit (Jumbo CD's) and repurchase agreements are also maintained as

marketable securities. Common stock may not be as appropriate to allow for the

firm's immediate cash needs because of its more volatile nature, but some firms

have issued money-market preferred stock with floating rate dividend yields.

So Marketable Securities include Stocks, bonds and other financial instruments

that organizations hold in lieu of cash. These are also referred to in the financial

statements as short-term investments.

Reasons for Holding Marketable Securities

Earning a higher rate of return than the one available in a bank account (i.e.,

cash).

The securities market is usually quite liquid, so such investments can be readily

converted into cash.

Management of these investments does not require ongoing operational

decisions. Rather, just a decision as to whether to buy or to sell is necessary.

Features of Suitable Marketable Securities:

1. Maturity: usually less than 90 days. This reduces interest rate risk.

2. Default Risk: usually very low

3. High degree of Liquidity

a. can be sold quickly

b. low cost of transaction

c. no price pressure effect when buying and selling

4. Tax considerations

a. firms often use municipal bonds, U.S. Government T-bills, etc.

b. dividend exclusions for corporations: up to 80%

Types of Marketable Securities

Firms normally confine their marketable securities investments to “money

market” instruments, that is, those high-grade (low default risk), short-term debt

instruments having original maturities of 1 year or less. Money market

instruments that are suitable for inclusion in a firm’s marketable securities

portfolio include U.S. Treasury issues, other federal agency issues, municipal

securities, negotiable certificates of deposit, commercial paper, repurchase

agreements, bankers’ acceptances, Eurodollar deposits, auction rate preferred

stocks, money market mutual funds, and bank money market accounts. (In some

cases, firms will also use long-term bonds having 1 year or less remaining to

maturity as “marketable” securities and treat them as money market

instruments.

Suitable Marketable Securities

1. US T-bills: mature in 90, 180, 270 or 360 days. Pure discount 90 & 180 days

sold by auction every week; others-every month.

2. US T-Bills & notes-longer than 1 year, no state and local taxes, fairly liquid

3. Federal agency securities: e.g., GNMA; not as marketable but low default risk.

Higher interest rate than treasury securities.

4. Short-term tax exempts-states, municipalities, local housing agencies and urban

renewal agencies. More default risk and less marketable. Federally tax exempt.

5. Commercial paper-short term securities-usually less than 270 day notes issued

by finance companies, banks and corporations. Secondary market can be inactive -

not always very marketable. However, issuers will often repurchase early. Moody's

Inc. and Standard and Poors Inc. publish quality ratings for these securities.

6. Certificates of Deposit (CD's) - issued by commercial banks and Savings and

Loan Institutions

7. Repurchase agreements: buy securities from a bond dealer with agreement for

dealer to repurchase at higher prices

8. Eurodollar CD's - dollar deposits in foreign banks

9. Bankers acceptances - time drafts or notes issued by firm that is guaranteed

payment by a bank.

Choosing Marketable Securities

A firm may choose among many different types of securities when deciding

where to invest excess cash reserves. In determining which securities to include

in its portfolio, the firm should consider a number of criteria, including the

following:

Default risk

Marketability

Maturity date

Rate of return

Notice that the first three criteria deal with risk and the last one deals with

return.

(1) Default Risk: - Most firms invest only in marketable securities that have

little or no default risk (the risk that a borrower will fail to make interest and/or

principal payments on a loan). U.S. Treasury securities have the lowest default

risk, followed by securities of other U.S. government agencies and, finally, by

corporate and municipal securities. Various financial reporting agencies,

including Moody’s Investors service and Standard & Poor’s, compile and

publish information concerning the safety ratings of the various corporate and

municipal securities. Given the positive relationship between a security’s

expected return and risk and the desire to select marketable securities having

minimal default risk, a firm has to be willing to accept relatively low expected

yields on its marketable securities investments.

(2) Marketability: - A firm usually buys marketable securities that can be sold

on short notice without a significant price concession. Thus, there are two

dimensions to a security’s marketability: the time required to sell the security

and the price realized from the sale relative to the last quoted price. If a long

period of time, a high transaction cost, or a significant price concession is

required to dispose of a security, the security has poor marketability and

generally is not considered suitable for inclusion in a marketable securities

portfolio. Naturally, a trade -off is involved here between risk and return.

Generally, a highly marketable security has a small degree of risk that the

investor will incur a loss, and consequently, it usually has a lower expected

yield than one with limited marketability.

(3) Maturity Date: - Firms usually limit their marketable securities purchases

to issues that have relatively short maturities. Recall that prices of debt

securities decrease when interest rates rise and increase when interest rates fall.

For a given change in interest rates, prices of longterm securities fluctuate more

widely than prices of short-term securities with equal default risk. Thus, an

investor who holds long-term securities is exposed to a greater risk of loss if the

securities have to be sold prior to maturity. This is known as interest rate risk.

For this reason, most firms generally do not buy marketable securities that have

more than 180 to 270 days remaining until maturity, and many firms restrict

most of their temporary investments to those maturing in less than 90 days.

Because the yields on securities with short maturities are often lower than the

yields on securities with longer maturities, a firm has to be willing to sacrifice

yield to avoid interest rate risk.

(4)Rate of Return: - Although the rate of return, or yield, is also given

consideration in selecting securities for inclusion in a firm’s portfolio, it is less

important than the other three criteria just described. The desire to invest in

securities that have minimum default and interest rate risk and that are readily

marketable usually limits the selection to those having relatively low yields.