Where some funds are not immediately needed for daily operations, they may be invested in a short-term portfolio, but if a substantial amount of funds are not needed, they must be separated and invested in a long-term portfolio. This is because short-term portfolio typically consists of very liquidity short-term maturity debt instruments (money market instruments) such as US T-bill, government agency securities, bank certificates of deposit, banker’s acceptances, Eurodollar time deposits, repurchase agreements, commercial paper, mutual funds, and tax-advantaged securities.

Computing yields on short-term instruments

Some money market instruments, such as T-bills and banker’s acceptances are quoted on discount-basis, i.e. they are issued at below face value and redeemed at face value with the difference representing interest. Others are interest-bearing, i.e. they accrue interest on their face value and the principal and interest are paid at maturity.

Discount\ Yield=\frac{F\ -\ P}{F}\times\frac{360}{t}

Money market yield vs bond-equivalent yield

While the nominal interest in both discount-based and interest-bearing instruments is the same, their yields differ. There are two types of yields: money market yield (MMY), which is calculated based on a 360-day year, and bond-equivalent yield (BEY), which is calculated on a 365-day year.

MMY=\frac{F\ -\ P}{P}\times\frac{360}{t}
BEY=\frac{F\ -\ P}{P}\times\frac{365}{t}

Yield differs from nominal interest because the purchase price in the discount-based instrument is lower than the face value. For example, if a discount-based instrument with 1 month to maturity has a face value of $500,000 and its nominal interest rate 4%, its purchase price would be$498,333 [=$500,000 × (1 – 1/12 × 4%)], and its yield would be: Yield=\frac{\$500,000-\$498,333}{\$498,333}\times12=4.013\%

Risks inherent in short-term investments

Short-term instruments carry risks such as credit risk, market (or interest rate risk), liquidity risk and foreign exchange risk.

When credit risk is a concern, investments should be moved to government securities.

Interest rate risk is minimized by opting for shorter maturities. It is because short-term securities generally have a lower duration.

Liquidity risk can be addressed by choosing government securities or securities for which an active secondary market exists.

Foreign exchange risk should be hedged using forward contracts, futures contracts, swaps, etc.

Short-term investment strategies

A passive strategy focuses on liquidity and security while aiming for a reasonable return, but it runs the risk of the company mechanically rolling over positions without analyzing yields. An active strategy requires more daily involvement and better forecasting of cash flows. Some active investment strategies (called matching strategies) attempt to match investment maturities with major cash outflows while others (mismatching strategies) do not, and hence, are riskier. A laddering strategy falls somewhere between active and passive strategies, and it spreads out investment maturities equally over the term of the ladder.

Investment policy statement for short-term investments

It is important to have a written investment policy statement to list out risk and return, liquidity, tax, and regulatory requirements, and special considerations that must be taken care of. The performance of a working capital portfolio should be compared using bond-equivalent yields. The composite return should be determined at the currency-size of the investment. A benchmark rate should be identified.