Marketable Securities Management quiz

Of the choices given, the commercial paper of a top-rated (mostcreditworthy) company has the least risk. Commercial paper is preferableto stock or stock options because the latter represent only a residual equityin a corporation. Commercial paper is debt and thus has priority overshareholders’ claims. Also, commercial paper is a very short-terminvestment. The maximum maturity allowed without SEC registration is270 days. However, it can be sold only to sophisticated investors withoutregistration.

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

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

A small firm with surplus cash should invest for the highest return andlowest risk. The ability to convert the investment into cash without a lossof principal is also important. Money market mutual funds invest in moneymarket certificates such as treasury bills, negotiable CDs, and commercialpaper. Because of diversification, these mutual funds are superior to anysingle instrument.

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

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

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 Statesgovernment, and the interest received is subject to federal income tax.

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

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

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 tofacilitate 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 Treasurybill to determine the amount of interest the lender will earn.

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

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

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

Term	Amount Invested	Discount	Nominal Return (Amount Invested  × Discount )
90 days	80,000	5%	4000
180 days	75,000	6%	4500
270 days	100,000	5%	5000
360 days	60,000	10%	6000

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%