Some Different Types of Money Market Securities

Money market securities are generally highly marketable and short-term. They usually have low risk of default. They are issued by the U.S. government (for example, U.S. Treasury bills), domestic and foreign banks (for example, certificates of deposit), and business corporations (for example, commercial paper). There are many types in all, and we only illustrate a few of the most common here.

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Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VII. Short-Term Financial Planning and Management

20. Cash and Liquidity Management

© The McGraw-Hill Companies, 2002

CHAPTER 20 Cash and Liquidity Management

U.S. Treasury bills are obligations of the U.S. government that mature in 30, 90, or 180 days. Bills are sold by auction every week.

Short-term tax-exempts are short-term securities issued by states, municipalities, local housing agencies, and urban renewal agencies. Because these are all considered municipal securities, they are exempt from federal taxes. RANs, BANs, and TANs, for example, are revenue, bond, and tax anticipation notes, respectively. In other words, they represent short-term borrowing by municipalities in anticipation of cash receipts.

Short-term tax-exempts have more default risk than U.S. Treasury issues and are less marketable. Because the interest is exempt from federal income tax, the pretax yield on tax-exempts is lower than that on comparable securities such as Treasury bills. Also, corporations face restrictions on holding tax-exempts as investments.

Commercial paper is short-term securities issued by finance companies, banks, and corporations. Typically, commercial paper is unsecured. Maturities range from a few weeks to 270 days.

There is no especially active secondary market in commercial paper. As a consequence, the marketability can be low; however, firms that issue commercial paper will often repurchase it directly before maturity. The default risk of commercial paper depends on the financial strength of the issuer. Moody's and S&P publish quality ratings for commercial paper. These ratings are similar to the bond ratings we discussed in Chapter 7.

Certificates of deposit (CDs) are short-term loans to commercial banks. The most common are jumbo CDs—those in excess of $100,000. There are active markets in CDs of 3-month, 6-month, 9-month, and 12-month maturities.

Repurchase agreements (repos) are sales of government securities (for example, U.S. Treasury bills) by a bank or securities dealer with an agreement to repurchase. Typically, an investor buys some Treasury securities from a bond dealer and simultaneously agrees to sell them back at a later date at a specified higher price. Repurchase agreements usually involve a very short term—overnight to a few days.

Because 70 to 80 percent of the dividends received by one corporation from another is exempt from taxation, the relatively high dividend yields on preferred stock provide a strong incentive for investment. The only problem is that the dividend is fixed with ordinary preferred stock, so the price can fluctuate more than is desirable in a short-term investment. However, money market preferred stock is a fairly recent innovation featuring a floating dividend. The dividend is reset fairly often (usually every 49 days), so this type of preferred has much less price volatility than ordinary preferred, and it has become a popular short-term investment.

Check out short-term rates on-line at www.bloomberg.com..

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