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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.
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.