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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 firms 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 Moodys Investors service and Standard & Poors, compile and publish information concerning the safety ratings of the various corporate and municipal securities. Given the positive relationship between a securitys 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 securitys 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 firms 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.