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(^214) Financial Management
Debt securities, with a contractual obligation to pay, are our best candidates. In selecting
among debt securities, there are three principal characteristics we should examine:
default risk, maturity and marketability.
Default risk refers to the possibility that interest or principal might not be paid on time
and in the amount promised. If the financial markets suddenly perceive a significant
risk of default on a particular secular security. The price of the security is likely to fall
substantially, even though default may not actually have occurred. Investors in general
are averse to risk, and the possibility of default is sufficient to depress the price. Given
our purposes in investing excess cash, we want to steer clear of securities that stand
any significant chance of defaulting. In an uncertain world, there is no guarantee that is
absolutely certain. With its capacity to create money. However, there are securities
available with default risk that is sufficiently low to be almost negligible. In selecting
securities, we must keep in mind that risk and return are related, and that low-risk
securities provide the lowest returns. We must give up some return in order to purchase
safety.
Maturity refers to the time period over which interest and principal payments are to be
made. A 20 years bond might promise interest semiannually and principal at the end of
the twentieth year. A 6-month bank certificate of deposit would promise interest and
principal at the end of the sixth month.
When interest rates vary, the prices of fixed-income securities vary. A rise in market
rates produces a fall in price, and vice versa. Because of this relationship, debt securities
are subject to a second type of risk. Interest rate risk, in addition to default risk. A
government bond, though free of default risk, is not immune to interest rate risk. The
longer the maturity of a security, the more sensitive its price is to interest rate changes
and the greater its exposure is to interest rate risk. For this reason, short maturities are
generally best for investing excess cash.
Marketability refers to the ease with which an asset can be converted to cash. With
reference to financial assets, the terms marketability and liquidity often are used
synonymously. Marketability has two principal dimensions-price and time-that are
interrelated. If an asset can be sold quickly in large amounts at a price that can be
determined in advance within narrow limits, the asset is said to be highly marketable or
highly liquid. Perhaps the most liquid of all financial assets are Treasury Bills. On the
other hand, if the price that can be realised depends significantly on the time available
to sell the asset, the asset is said to be illiquid. The more independent the price is of
time, the more liquid the asset. Besides price and time, a third attribute of marketability
is low transaction costs.