A key element of working capital optimization is the short-term investment strategies treasurers undertake. They are a vital tool of risk management, but are somewhat more limited in their type and maturity than long term strategies.
Liquidity and security are the twin objectives managers look for in short term investments.
Short- term strategies fall into two broad categories, passive and active. A passive strategy involves having some basic ground rules that dictate how daily investments are done. An active strategy, on the other hand, sees the manager closely monitoring and managing the investments. The active strategy could use matching, mismatching and laddering.
The primary focus of passive strategies is definitely security and liquidity. However this is strategy sometimes becomes the complacent strategy, wherein initial investments on maturing are simply rolled over to the next period without checking for other alternative investments. A passive strategy that measures investment yields on maturity with say a T-bill can mean good returns.
An active strategy as the name suggests requires a more hands-on or involved approach. In this strategy managers scout for more investment products, monitor their yield on maturity and then decide to roll over to the next period. An active strategy is indicative of a company that is more flexible in their investment approach.
Both the approaches are based on cash outflow forecasts. In the active format, the maturity of the investments can either match or mismatch the cash outflows.
A matching strategy could use T-bills as an investment type. It is more conservative and allows for the instrument to be encashed should market conditions turn adverse. The mismatching strategy is more likely to use investment tools like derivatives, which can prove dangerous if the company has little or no experience in dealing with them.
A more balanced strategy is the ladder strategy, which has characteristics of a passive strategy and a matching strategy. In this strategy the maturity of the investments are scheduled at systematic intervals just as in a ladde
In the light of the recent sub-prime mortgage crisis, which led to a short-term liquidity crisis, it is important which type of short-term investment strategy a company decides to implement. The short-term investment strategy depends on the risk policy of the company. Everyone seeks high returns on their investments, which can sometimes be detrimental. It is important to assess the risk appetite of the company and align it with its investment strategy. Clear written down guidelines can help implement the short-term investment policy.