Selecting securities for the portfolio segments

The Decision to invest cash in marketable securities involves not only the amount to invest but also the type of security in which to invest. Our earlier partitioning of the firm’s marketable securities portfolio into three segments helps us in making these determinations. An evaluation of the firm’s expected future cash-flow patterns and the degree of uncertainty associated with them is needed to help determine the size of the securities balances to be found in each segment.

For securities comprising the firm’s ready cash segment (R$), safety and an ability to convert quickly into- cash are primary concerns. Because they are both the safest and most marketable of all money market instruments, Treasury bills make an ideal choice to met the firm’s unexpected needs for ready cash. Short-term, high-quality repos and certain highly liquid, short-term municipals can also play a role. If, for example, overnight repos are secured by Treasury securities and continually rolled over (reinvested into other repos), funds can remain invested while providing continuing liquidity and safety of principle.

The second segment of the firm’s securities portfolio, the controllable cash segment (CS), holds securities earmarked for meeting controllable (knowable) outflows, such as payroll, payables, taxes, and dividends. Here the presumption is that the required conversion date to cash is known (or, at least, can be forecast to fall within very narrow limits). Thus, securities in this segment would not necessarily have to meet the same strict requirement for immediate marketability as those in the ready cash segment.

The portfolio manager may attempt to choose securities whose maturities more accurately coincide with particular known cash needs — like a quarterly dividend payment or a large bill due on the 15th of the month. For this segment, federal agency issues, CDs, commercial paper, repos, bankers’ acceptances, euro-dollar deposits, and MMPs would warrant consideration. Also, though safety and marketability would still be important i0ssues of concern, the portfolio manager would place more emphasis on the yield o-f the securities in this segment than would be placed on securities in the ready cash segment.

Finally for securities forming the firm’s free cash segment (FS) of its securities portfolio the date of needed conversion into cash is not known in advance just like for the ready cash segment but there is no overriding need for quick conversion. The portfolio manager may feel that yield is the most important characteristics of securities to be considered for this segment.

Higher yields can generally be achieved by investing in longer term, less marketable securities with greater securities with greater default risk. Although the firm should always be concerned with marketability, some possibility of loss of principal is tolerable, provided the expected return is high enough. Thus, in this segment (as in the other two), the firm faces the familiar trade-off between risk and return.