Managing Marketable Securities
Marketable securities are an investment option for organizations with strong liquidity and some potential strategic purposes in risk aversion.
Understand the various forms of marketable securities, and their value in corporate finance
- Marketable securities are listed on the balance sheet as cash and cash equivalents, short term investments, and long term investments.
- The primary purpose of investing in marketable securities is the opportunity to capture returns on existing cash, while still maintaining easy access to cash flow (due to the high liquidity ).
- Marketable securities include debt securities, equity securities, and derivatives. Debt securities tend to be longer term, lower risk, and lower return.
- Equity primarily refers to stock and preferred stock, which can be used as a basic investment device to capture returns on existing cash (with higher risk than debt securities).
- Derivatives are a bit more complex. Derivatives are often used in hedging, which is the process of investing existing cash to offset external risks such as variances in commodity prices, interest rates, and foreign currency fluctuations.
- derivatives: An investment option valued at the performance of an underlying asset.
What Are Marketable Securities?
This is a broad term that encompasses investments a business may make within the securities market. The advantages of these types of securities can vary depending on the business, but generally they are valuable investments with reasonably high returns that are still easily translated into cash. It is also worth noting that these types of investments can be used to hedge various types of risks. These types of investments are reported on a balance sheet as cash and cash equivalents due to their liquidity (as well as short term investments and, in some instances, long term investments), and can provide businesses with rapid access to capital.
Types of Marketable Securities
Marketable securities can include a variety of business investments, most of which are easily exchanged via a public exchange. These include debt securities, equity securities, and derivatives. Each of these investment types have different degrees of risk (and respective return), as well as relatively different functions from a strategic investing point of view.
The most common types of debt securities are corporate bonds, government bonds, and money market instruments. Bonds function on fixed term contracts, generally long term, offering a fixed rate of return at an extremely low level of risk. The reason the risk is so low on these particular instruments is due to the fact that in the circumstance of a bankruptcy or default on payments on behalf of the representing organization (in commercial bonds the company who issued it, and on government bonds the government that issued it), the holder of a debt security will be among the first stakeholders paid out when assets are liquidated.
Another common instrument of investment for organizations investing in cash equivalents is common and preferred stock. Buying equity in other organizations can provide a variety of benefits, depending on the scale of the investment being made. Equity investments tend to yield higher returns (at higher risk), while also granting shareholders a percentage of ownership over the organization being invested in.
Perhaps the most interesting marketable securities (and often the highest risk) are derivatives. As the name implies, derivatives derive their value from the performance of an underlying asset. These underlying entities can be indexes, assets, interest rates, or a variety of other financial devices. The reason they can be so dangerous is due to the fact that, as derivatives of another asset, they can be subjected to an amplification of the risk the underlying asset is subjected to. The 2008 economic recessions is largely due to the irresponsible utilization of derivatives (in that case, primarily those reliant upon debts, such as home mortgages).
However, at the business level, derivatives have unique value due to the ability to hedge against various risks. Hedging is the process of purchasing derivatives counter to business risks being experienced, in order to offset any fluctuation in the external environment which may adversely effect profitability. This sounds confusing, but is actually much simpler than it seems. Let’s take a couple examples:
- Hedging against foreign currency risk – When operating in a global market different than that of the home office, it is common to encounter the risk of fluctuating currencies. Let’s say that a company operating in both the United States and Australia (headquartered in the United States) is worried about exposure to the Australian dollar. They obtain 50% of their revenue in Australian dollars, and therefore have a great deal of short term assets in Australian dollars. By purchasing derivatives, the organization can profit from a decrease in value for the Australian dollar to offset what would have been lost in the valuation of their short term assets.
- Hedging against commodity prices – Let’s consider another example, but this time with inventory. You own a coffee shop, so naturally you’re buying a lot of coffee beans. You budget $500,000 for the purchase of coffee beans over a given quarter for all of your many successful locations. However, you buy them in batches over time. If the price of coffee beans spikes up, you’re $500,000 won’t buy you nearly as many coffee beans as you projected you would need. As a clever investor, you purchased derivatives in coffee beans to make sure you would offset this loss with profits in the exchange market.