Short-term instruments

Bills of exchange

Bills of exchange are commonly used in international trade. They help a buyer purchase goods from an overseas supplier when the buyer can’t (or doesn’t want to) pay immediately.

Here’s the main idea:

• A buyer wants to purchase goods (for example, expensive machinery) from a supplier in another country.
• The buyer’s bank draws up a bill of exchange on the buyer’s behalf.
• The bill is sent to the supplier’s bank overseas, which then delivers it to the supplier.

Because the buyer and supplier are in different countries, banks typically handle much of the verification and processing.

In some cases, the buyer’s local bank may pay the supplier immediately. The buyer then repays the bank on a future date, usually with an additional return for the bank.

If the bank does not pay immediately, the supplier may choose to sell (discount) the bill to a bank. In that case, the bank pays the supplier the face value of the bill minus its charges. For example, if a bill of exchange is worth $\$10,000$, the bank may pay the supplier $\$9000$. When the customer later pays the full $\$10,000$, the bank receives $\$10,000$ and earns $\$1,000$ as profit from the transaction.

A bill of exchange doesn’t usually state an interest rate like a bank loan. Instead, the investor’s return (the buyer of the bill of exchange) comes from the difference between the face value ($\$10,000$) and the amount paid to purchase the bill ($\$9000$).

Characteristics

Yield: Usually lower because there is no stated interest rate; the investor’s return comes from discounting (as described above).

Risk: Generally lower risk if approved/guaranteed by banks and issued by prominent entities. If not, risk is higher because the supplier or the buyer of the bill may not get their money back.

Maturity: Short-term in nature, typically under one year.

Liquid: If guaranteed by banks, they can be sold in the money market and are therefore liquid. If not guaranteed, liquidity is much lower.

Divisibility/Value: Normally less standard because overseas transactions vary.

Transaction costs: Normally low; otherwise buying the instrument wouldn’t be worthwhile.

Certificate of deposits

Many investors consider certificates of deposit (CDs) among the safest short-term investments because the investor is dealing with a bank that guarantees the transaction. However, it’s important to remember that nothing is ever 100% guaranteed in finance.

There is usually a minimum amount required to invest in a certificate of deposit. One reason is that interest returns are often relatively low, so larger investments can make the return more worthwhile - especially since CDs are typically short-term.

Characteristics

Yield: Usually lower due to the short maturity period and the fact that it’s considered a safe investment.

Risk: Usually low because it is offered by a bank.

Maturity: Usually short term (1 year or below).

Liquidity: Normally highly liquid since they can be traded in the money market.

Divisibility/Value: There is normally a minimum amount requirement.

Transactional costs: Normally low; if they are high, the instrument becomes unattractive.

Credit agreements

Credit agreements are common arrangements between customers and retail outlets. They are often among the most expensive funding options because they typically charge high interest. Credit cards are a common example.

Characteristics

Yield: normally higher because credit cards are known for high interest rates.

Risk: normally high, which helps explain the high interest rates. A customer may default or avoid repayment, meaning the full amount may never be recovered.

Maturity: usually short term in nature (12 months and below).

Liquidity: less liquid because borrowers generally can’t sell the debt to someone else who is willing to take it over.

Divisibility/Value: no standard amount, because the amount of credit one customer wants will differ from another.

Transactional costs: normally low or none.

Calculation of return to investors/growth/yield

Dividend growth: This calculates the percentage growth of dividends paid to ordinary shareholders. It is calculated from the investor’s point of view.

The following is the formula for the calculation:

Dividend yield formula

$$\text{Dividend yield}=\frac{\text{Dividend per share}}{\text{Market price per share}}\times 100\%$$

Example 1

KTA is a venture capitalist who invests in shares of small and large companies. One year ago, KTA bought shares from a listed company. The market price of the shares is currently $\$100$, with a nominal value of $\$20$. The company paid dividends of $\$2$ per share in the most recent period.

Solution

This means the investor is seeing a dividend yield of $2\%$ per year. Whether that is high or low depends on the industry average.

Bonds

Your exam will test you on the following:

Definitions

Bill rate

Essentially the interest rate

Interest yield

The return an investor earns from investing in bonds

Interest yield formula

$$\text{Interest yield}=\frac{\text{Annual interest payment}}{\text{Market value of the bond}}\times 100\%$$

Example 2

KTA bought bonds last year. The bonds are currently trading at $\$120$ with a coupon rate of $5\%$. The par value of the bond is $\$100$. Calculate the interest yield of these bonds.

Solution

When faced with a long-term project should a company lock itself in the long term or borrow in the short term?

When an organization is deciding whether to borrow short term or long term, it should consider which funding options are realistic for its situation.

For short-term borrowing, the following can be used:

• Bank overdraft
• Commercial paper
• Short term loans
• Delaying payables

When the company is considering borrowing in the long term, here are the options available at its disposal:

• Equity shares
• Preference shares
• Long-term bank loans
• Bonds
• Convertible bonds/preference shares

Projects that are considered high risk are more likely to be funded by equity, since the company does not have to repay the money in the same way it would with debt - especially if the project performs poorly.

If a company is facing a week or two weeks of cash shortages, it can use an overdraft to finance that short-term decline.

Organizations can also invest in financial instruments when they have excess cash. The choice depends on when they will need the money back:

• If it’s a matter of a few months, the entity can invest in the money market.
• If it’s a matter of years, investments can be made in the long term (capital markets).