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Flashcards in Working Capital - Short-Term Securities Deck (4):
1

Temporary excess cash; invest

Earn a greater return than that would be provided by idle cash.

2

Considerations short-term investments

Safety of principal - Should have little risk of default. Default risk is a measure of likelihood that issuer will not be able to make future interest and/or principal payments to a security holder

Price stability - Should not be subject to market price declines that would result in significant losses if securities were sold for cash

Marketability/liquidity - Investments should have a ready market for converting securities to cash without incurring undue cost (liquidating securities)

3

Investment opportunities in money market

US Treasury Bills - Virtually risk-free; increments of 5k with minimum 10k investment; 3 months - 6 months - 1 year

Federal agency securities - Securities are obligations of a federal gov agency (Fannie Mae, Federal Land Bank). Are not backed by good faith and credit of federal government; slightly more risk than treasury

Negotiable COD - issued by banks in return for a fixed time deposit with bank. Can be brought or sold on secondary market unlike conventional COD.

Bankers' acceptances - draft (order to pay) drawn on a specific bank by a firm which has an account with the bank. Primary use is on financing foreign transactions. 30-180

Commercial paper - short-term unsecured promissory note issued by large, establish firms with high credit ratings few days - 270.

Repos - firm makes an investment (loan) and enters into a commitment to resell the security at the original contract price plus agreed interest for holding period. Large denominations and have specified maturities. a. The time of the agreement (maturity) can be adjusted to any length, including as short as one day.
b. Since the agreement provides for resale of the investment at the original price (plus interest), the risk of market price declines is avoided.

4

Investment Assessment

n making short-term investments of temporary excess cash, a firm likely will give priority to avoiding risk, rather than maximizing return.

Coefficient of Variation -- one measure used to assess the risk-reward relationship (for either short-term or long-term investments) is the coefficient of variation.
1. The coefficient of variation is a measure of the relative variability (or dispersion) of return values around the mean return; it can be thought of as a measure of the total risk per unit of return.


Coefficient of variation (CV) = SD/AR
Where: SD = Standard deviation of investment average return (which is a common measure of how much an investment deviates from its average performance; that is, its volatility.)

The lower an investment's coefficient of variation, the better its total risk-return trade off. If the AR (used as the denominator) is zero or negative, the resulting ratio (coefficient) will not be valid and the CV cannot be used to assess risk for that investment


Sharpe Ratio—another measure used to assess the risk-reward relationship (for either short-term or long-term investments)

Sharpe ratio = (AR − RR)/SD
Where: AR = Average Rate of return of investment
RR = Average Risk-free rate of return
SD = Standard deviation of investment average return (which is a common measure of how much an investment deviates from its average performance; that is, its volatility)

^The greater an investment's Sharpe ratio, the better its risk-adjusted performance. A negative ratio indicates that an investment with no risk would perform better than the investment being analyzed

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