Marketable security

What Is Marketable Security?

A marketable security is a financial asset that can be quickly and easily converted into cash at its prevailing market value without significantly affecting its price. These assets are characterized by their high liquidity and are considered an essential component of a company's current assets on its balance sheet. Marketable securities fall under the broader category of investment vehicles or financial assets. Companies often hold marketable securities to earn a return on excess cash while maintaining flexibility for immediate financial needs.

History and Origin

The concept of marketable securities, particularly short-term debt instruments, has roots in the historical development of money markets. For instance, commercial paper, a type of unsecured promissory note issued by corporations, traces its origins back over a century. New York merchants in the 19th century began selling their short-term obligations to dealers, who then passed them to banks or other investors. Marcus Goldman, the founder of Goldman Sachs, played a pioneering role as a dealer in this nascent money market, purchasing commercial paper from businesses as early as 1869.³ This practice allowed companies to raise short-term funds efficiently, laying groundwork for today's diverse marketable securities market.

Key Takeaways

Marketable securities are highly liquid financial instruments that can be converted into cash quickly.
They typically include short-term debt securities (such as Treasury bills and commercial paper) and certain equity securities.
Companies hold marketable securities to generate returns on idle cash while maintaining financial flexibility.
These securities are reported as current assets on a company's balance sheet.
While offering high liquidity and low risk compared to other investments, they generally yield lower returns.

Formula and Calculation

Marketable securities do not have a single universal formula, as they encompass various types of financial instruments. However, their valuation typically revolves around their present value or the calculation of their yield.

For discount instruments like Treasury bills, the return (yield) is calculated based on the difference between the purchase price and the face value at maturity. The Bank Discount Rate for a Treasury Bill, for example, is calculated as:

\text{Bank Discount Rate} = \frac{\text{Face Value} - \text{Purchase Price}}{\text{Face Value}} \times \frac{360}{\text{Days to Maturity}}

Where:

Face Value = The par value of the security, paid at maturity.
Purchase Price = The discounted price at which the security is bought.
Days to Maturity = The number of days remaining until the security matures.

For interest-bearing marketable securities like some fixed income instruments, the calculation might involve determining the yield to maturity based on coupon payments and the current market price.

Interpreting the Marketable Security

Marketable securities are interpreted primarily in terms of their liquidity and their role in a company's financial health. A substantial holding of marketable securities indicates that a company has ample cash reserves that are earning a return, even if modest. This can signal financial stability and the capacity to meet short-term obligations or seize opportunistic investments without needing to borrow heavily.

For investors, the presence and composition of marketable securities on a company's balance sheet can offer insights into its cash management strategies. Companies might hold these assets to provide a buffer against unforeseen expenses or as a temporary holding place for funds awaiting deployment into longer-term projects or acquisitions. The ease with which these assets can be converted to cash, often through active secondary markets, underscores their financial utility.²

Hypothetical Example

Consider "Tech Innovations Inc." which recently sold off a non-core division, resulting in an influx of $50 million in cash. Instead of letting this substantial sum sit idly in a checking account, the company's treasury department decides to invest a portion of it in marketable securities to earn a modest return while keeping the funds accessible.

Tech Innovations Inc. allocates $20 million to purchase Treasury bills with maturities ranging from 3 to 6 months. They buy $10 million in 3-month T-bills at a discounted price of $9,950,000 (reflecting a 2% annualized discount yield) and $10 million in 6-month T-bills at $9,900,000 (reflecting a 2% annualized discount yield).

At the end of three months, the first batch of T-bills matures, returning $10 million to the company, providing immediate liquidity that can be used for upcoming payroll or a planned equipment upgrade. The remaining 6-month T-bills continue to earn their yield until their maturity, illustrating how marketable securities allow a company to manage cash flow effectively while generating some income.

Practical Applications

Marketable securities are widely used across various financial domains:

Corporate Cash Management: Companies utilize marketable securities to manage their short-term cash surpluses. Instead of holding idle cash, they invest in these instruments to earn a return, ensuring funds remain available for operational needs, dividends, or acquisitions.
Liquidity Management: Financial institutions, including banks and investment funds, rely on marketable securities to maintain high levels of liquidity. These assets can be quickly sold to meet withdrawal demands or unforeseen obligations.
Government Finance: Governments issue marketable debt securities, such as Treasury bills, to finance short-term funding needs and manage public debt. The U.S. Department of the Treasury publishes daily rates for various Treasury bills, reflecting their active trading in the money market.
Portfolio Construction: While primarily short-term, marketable securities can be part of an investor's overall diversification strategy, offering a low-risk component to balance more volatile assets. They are a common feature of money market funds.

Limitations and Criticisms

While marketable securities offer significant advantages in terms of liquidity and safety, they are not without limitations. A primary criticism revolves around their generally lower returns compared to longer-term or higher-risk investments. Because these securities are designed for capital preservation and immediate access to funds, the interest rates or capital gains generated are typically modest.

Another limitation is the exposure to interest rate risk, especially for debt securities. If interest rates rise, the market value of existing marketable debt securities with fixed interest rates may fall, albeit usually minimally due to their short maturities. Furthermore, while highly liquid, extreme market stresses can still impact even the most "cash-like" assets. During periods of financial turmoil, the underlying assets of highly liquid instruments like money market funds, which hold many marketable securities, can experience vulnerabilities related to funding risks, as observed in various stress episodes.¹

Marketable Security vs. Short-Term Investment

The terms "marketable security" and "short-term investment" are often used interchangeably, but there's a subtle distinction. A marketable security specifically refers to an investment that is both short-term (typically maturing within one year) and readily salable in an active market. Its key characteristic is its liquidity and the ease of conversion to cash at a predictable price.

A "short-term investment," on the other hand, is a broader category that refers to any investment held for a period of less than one year. While many short-term investments are indeed marketable securities (e.g., Treasury bills, commercial paper, actively traded stocks intended for quick sale), not all short-term investments meet the "marketable" criteria. For example, a loan due in six months to a private entity might be a short-term investment, but it is not a marketable security if there is no active secondary market for it. The defining feature of a marketable security is its unrestricted tradability on a public exchange.

FAQs

What are common examples of marketable securities?

Common examples of marketable securities include U.S. Treasury bills, commercial paper issued by highly-rated corporations, certain actively traded equity securities (stocks) that a company intends to sell quickly, and money market instruments.

Why do companies hold marketable securities?

Companies hold marketable securities to ensure they have sufficient liquidity to meet immediate operational expenses, unexpected needs, or to take advantage of short-term investment opportunities. It allows them to earn a modest return on their excess cash reserves instead of letting the cash sit idle.

Are marketable securities considered current assets?

Yes, marketable securities are classified as current assets on a company's balance sheet because they are expected to be converted into cash within one year. This classification highlights their role in a company's short-term financial health.

What is the primary risk associated with marketable securities?

The primary risk associated with marketable securities is often interest rate risk, where rising interest rates can cause the value of existing fixed-income marketable securities to decline. However, due to their short maturities, this risk is generally limited compared to longer-term bonds. They also carry a low level of credit risk, depending on the issuer.