Investing Excess Cash: Reducing Speculation
The thin line between investing and speculation is often blurred. Unfortunately, many who are directly responsible for their organization's investments have difficulty in separating speculation from investment. As a result, they may undertake a higher risk with corporate investments than is warranted. IMPORTANCE OF IDENTIFYING SPECULATION This article discusses how to identify and contain speculation. The material is of value to those individuals responsible for investing excess corporate cash. Such individuals include * Senior treasury management personel. In relying on subordinates to implement an investment program, these individuals sometimes are unaware of inappropriate investment strategies. * Cash or treasury management personel who execute the investment transactions. Without specific guidance, these individuals could make decisions that management deems too speculative. * Auditors (internal or external). Because the individuals responsible for monitoring a corporation's financial activities usually are not experts in investment strategy, they could have difficulty recognizing potential or existing investment problems until it is too late. Since investing is subjective, an organization first must develop standards to distinguish between investment and speculation. These standards then must be used to put together a statement of investment policy and guidelines which define a prudent investment program designed to avoid investment risk. Investment activities that fall outside the guidelines should be considered unacceptable. TYPES OF RISK Here is a brief discussion of some major investment risks. * Credit or default risk, simply stated, is the possibility that the investor's principal and/or interest will not be returned when due. Speculation occurs when instruments with low credit ratings or high default risks are purchased to obtain higher yields. * Market or interest rate risk refers to the possible decline in the market value of fixed-income securities if interest rates rise. The longer the maturity on the instrument, the more prices are affected by interest-rate changes. A speculator may purchase a longer maturity solely for the potential price increase if interest rates decline. This price increase potential encourages speculation in long-term, interest-bearing securities. * Liquidity risk refers to the inability to convert an instrument to cash, with little or no penalty for the conversion. (Instruments that can be readily sold are highly liquid instruments.) However, instruments that provide little or no liquidity generally carry a higher rate of return to reward the investor since they cannot be converted quickly to cash. A speculator who seeks out these instruments for the higher yield might not consider the risk of illiquidity. RISK CONTAINMENT The following paragraphs outline elements that should be included in forming an investment policy to reduce speculation. * Investment committee. A group of senior management, perhaps members of the board of directors, should be formed to address management's investment goals. * Policy statement. A policy statement may be a brief declaration of management's attitude toward risk versus reward. It should address whether or not the organization desires funds exposed to greater risk to capture additional yields. For example, a policy statement might read, "The investment objectives of Organization X, in order of their importance, shall be safety of principal, liquidity and a competitive rate of return." * Investment responsibility. Individuals responsible for executing investments and maintaining all related documentation should be authorized by title in the investment guidelines. Furthermore, at least two individuals should be given this authority to ensure that one is available at all times. …