Investment Criteria?

A firm might invest excess cash in many types of interest-bearing assets. To choose among the alternatives, we must establish criteria based on our reasons for investing excess cash in the first place. We are investing either temporary transaction balances or precautionary balance or both. When we need the cash, we want to be able to obtain it-all of it-quickly. Given these objectives, we can rule out equity share and other investments with returns that are not contractual and with prices that often vary widely.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.

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