1. SHORT-TERM FINANCIAL MANAGEMENT Chapter 14 – Short-Term Investing

2. S HORT -T ERM I NVESTING Chapter 14 2 Define an investment policy and indicate what inputs are used to develop the policy, evaluate portfolio performance, specify the important features of the various money market instruments, calculate yields for money market instruments, specify types of investment risk and their effects on yields, and explain yield curve theories.

3. S/T Investment Management 3  Firms work hard to forecast cash positions.  With that information, the firm can develop short- term investing and financing strategies.  Through planning, a firm knows not only if it has extra cash, it knows for how long it will have it.  It can take advantage of better rates from longer maturities at lower transaction costs.

4. S/T Investment Management 4  The firm must first decide what portion of assets to hold in cash and securities, and then how to allocate surplus funds between cash and securities ( cash and securities mix decision ).  A portion of the surplus must remain in cash, a non- productive asset but one necessary to operate.  The lower the liquidity, the riskier the strategy but the higher the expected return.  Firms must also decide whether to make investment decisions internally or hire outside professionals.

5. S/T Investment Management 5  Firms design short-term portfolios which balance risk and return.  The investment manager makes decisions that meet stated investment objectives outlined in the written investment policy.  Usually, the strategy calls for specificity around ‘safety, liquidity, and yield.’  The policy must align with management and shareholder risk tolerances, and not violate any restrictions (such as loan covenants).

6. Investment Policy 6  The Investment Policy includes:  Instruments Foreign or domestic Type Money Markets (treasuries, agencies, money market funds, commercial paper, CDs, etc.) Capital Markets (preferred stock, common stock, bonds, etc.)  Types of Issuers – Treasury, federal agency, municipality, or corporate  Minimal Acceptable Ratings / Risk Tolerance  Required Diversification – Dollar-limits or percent of portfolio  Minimum Denominations  Maturity Limits  Yield (Return) Expectations  Performance Management

7. Nature of the Money Market 7  Primary and secondary markets  Wholesale and retail markets  Money market interest rates  Highly correlated ( ≈.99)  Tax status: Most are taxable  Market mechanics and intermediaries  Dealers vs. Brokers

8. Money Market Instruments 8  Bank Instruments  Sweep Accounts  Certificates of Deposit (CDs)  Time Deposits  Banker’s Acceptances  Loan Participations  Securitized Assets  Eurodollar Deposits  Mixed Instruments  MMMF  Repurchase Agreements  Corporate Instruments  Commercial Paper  Floating Rate Notes  Common Stock  Preferred Stock  Federal Gov’t Instruments  Treasury Securities  Agency Instruments  State and Local Gov’t Instruments

9. S/T Strategies 9  Matching  Strategy involves purchasing short-term securities that mature when funds are needed.  Laddering  Strategy involves a pattern of rolling maturities. Hedges interest rate risk and allows for longer maturities.

10. Money Market Rate Calculations 10 Dividend capture yield Tax-equivalent yield Where:.30 is related to the dividend exclusion T is the investors marginal tax rate D is the dividend P is the security price n is the holding period (Must be at least 46 days)

11. Money Market Rate Calculations 11 Discount yield Coupon-equivalent yield

12. Calculating Portfolio Returns 12  During the year, money is alternately invested and withdrawn throughout the period.  We need an equation to convert intra-year rates of return to the annual equivalent rate. INSERT IMAGE HERE  It is the product of (1 + the period rates of return) - 1

13. Calculating Portfolio Returns 13  Assume the following portfolio activity:

14. Calculating Portfolio Returns 14  Calculate the holding period returns:  Calculate the effective annualized return:  = [(1.04)(1.0316)(1.046)(1.027)] - 1 = 15.3%

15. Alternatively… 15  Calculate the EAR for each period:  Calculate the average of the EARs:  = (.1699 +.1324 +.1970 +.1126) / 4 = 15.3%

16. Term Structure: Unbiased Expectations 16  The prevailing yield curve is derived from the present short- term rate and expectations for rates that will exist in the future.  (1+ t R n ) = [(1+ t R 1 )(1+ t+1 r 1,t )(1+ t+2 r 1,t )......] 1/n  Where t R n = spot rate for 1-year security as of period t  t+1 r 1,t = forward rate, the rate the market thinks will  exist at period t+1, for 1-year security,  predicted as of period t.  Thus, long-term rates are higher than current short-term rates if future short-term rates are expected to be higher than current short-term rates...and long-term rates fall below current short-term rates if future expected short-term rates are expected to be less than the current level of short-term rates.

17. Term Structure: Unbiased Expectations 17  I prefer the following notation:  0 S n = Spot rate for a n-period security  p F q = Forward rate for a (p – q)-period security beginning at time p and ending at time q.  Example:  (1+ 0 S 2 ) 2 = (1+ 0 S 1 )(1+ 1 F 2 )  (1+ 0 S 3 ) 3 = (1+ 0 S 2 ) 2 (1+ 2 F 3 )  (1+ 0 S 3 ) 3 = (1+ 0 S 1 )(1+ 1 F 2 ) 2  What is the expected one-year interest rate on securities purchased two years from now?

18. Term Structure: Liquidity Preference 18  Preference for liquidity is thought to characterize enough investors that the yield curve (in absence of expectations or other influences) should slope upward from left to right. The longer the maturity, the higher the premium demanded by investors.  0 S 2 = 0 S 1 + k t

19. Term Structure: Segmentation hypothesis 19  Instead of being close substitutes, securities with short, medium, and long maturities are seen by investors (fund suppliers) and issuers (fund demanders) as quite different.  The markets are thus separated, or segmented, by the self-limiting behavior of institutions staying within their preferred habitats.

20. Term Structure: Biased expectations 20  A combination of the unbiased expectations theory and the liquidity preference hypothesis.

21. Risk Structure of Interest Rates  Default risk  Chance that an owed cash flow (interest or principal) will not be paid on time.  Liquidity risk  Chance that the security can not be sold quickly without significant loss of value.  Interest rate risk (Price risk)  Chance of a change in the value of a security due to a change in market interest rates.

22. Risk Structure of Interest Rates  Reinvestment rate risk  Chance that interim cash flows can not be invested to earn the same yield as the security.  Event risk  Chance that an “event” will change the value of a security.  Foreign exchange and political risk  Chance that the value of the cash flows from a security may be lowered due to a change in exchange rates or due to action by a governing body.

23. Risk-Return Assessment in Practice  Yield spread analysis  There should be a default risk premium, but the empirical evidence is mixed.  Safety ratings  Moody’s and Standard & Poor’s – Relative probability of default