Marketable Securities Management quiz

Of the choices given, the commercial paper of a top-rated (most creditworthy) company has the least risk. Commercial paper is preferable to stock or stock options because the latter represent only a residual equity in a corporation. Commercial paper is debt and thus has priority over shareholders’ claims. Also, commercial paper is a very short-term investment. The maximum maturity allowed without SEC registration is 270 days. However, it can be sold only to sophisticated investors without registration.

To determine the amount of interest the lender will earn, the 3.5% discount rate is multiplied by the face amount of the Treasury bill. The interest on this Treasury bill is $3.50 ($100 × 3.5% × 1 year). Thus, the purchase price is $96.50 ($100 – $3.5)

U.S. Treasury bills have no coupon rate because they are sold at a discount. They are backed by the full faith and credit of the United States government, and the interest received is subject to federal income tax.

Marketable securities are near-cash items used primarily for short-term investment. Examples include U.S. Treasury bills, Eurodollars, commercial paper, money- market mutual funds with portfolios of short-term securities, bankers’ acceptances, floating rate preferred stock, and negotiable CDs of U.S. banks. A convertible bond is not a short-term investment because its maturity date is usually more than 1 year in the future and its price can be influenced substantially by changes in interest rates or by changes in the investee’s stock price.

A Treasury bill is a short-term U.S. government obligation that is sold at a discount from its face value.

A Treasury bill is highly liquid and nearly risk-free, and it is often held as a substitute for cash.

Bonds are long-term financial instruments. Thus, they are an inappropriate temporary investment of cash.

A small firm with surplus cash should invest for the highest return and lowest risk. The ability to convert the investment into cash without a loss of principal is also important. Money market mutual funds invest in money market certificates such as treasury bills, negotiable CDs, and commercial paper. Because of diversification, these mutual funds are superior to any single instrument.

The first step is to calculate the nominal return that each investment will provide:

The next step is to restate the nominal returns on an annualized basis:

Term        Nominal Return        Fraction of Year    Annualized Return
90 days           4,000             ÷         (90 ÷ 360)               = $16,000
180 days          4,500            ÷        (180 ÷ 360)              = 9,000
270 days          5,000           ÷        (270 ÷ 360)               = 6,667
360 days         6,000            ÷        (360 ÷ 360)              = 6,000

The final step is to calculate the annual yield of each investment.

Term       Annualized Return       Amount Invested      Annual Yield
90 days            16,000            ÷               80,000                     = 20.0%
180 days            9,000            ÷              75,000                      = 12.0%
270 days            6,667            ÷               100,000                   = 6.7%
360 days           6,000            ÷               60,000                     = 10.0%

A short-term security issued by a corporation or agency created by the U.S. government, such as the Federal Housing Administration, is an agency security (agency issue). Among the largest issuers of agency securities (excluding the Treasury) are the Federal Home Loan Banks, the Federal National Mortgage Association (Fannie Mae), and the other entities thatprovide credit to farmers and home buyers. Other issuers of home mortgage-backed securities include the Government National Mortgage Association (Ginnie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Cash and short-term investments are crucial to a firm’s continuing success. Sufficient liquidity must be available to meet payments as they come due. At the
same time, liquid assets are subject to significant control risk. Therefore, liquidityand safety are the primary concerns of the treasurer when dealing with highly
liquid assets. Cash and short-term investments are held because of their ability to facilitate routine operations of the company. These assets are not held for
purposes of achieving investment returns.

The 6% discount rate is multiplied times the face amount of the Treasury bill to determine the amount of interest the lender will earn.

The interest on this Treasury bill is $3 ($100 × 6% × .5 year).

Thus, the purchase price is $97 ($100 – $3).