CFA Level I Exam · Working Capital and Liquidity

Short-Term Investment Policy and Instruments for CFA Level I

Updated 7 October 2026 · Fact-checked

Short-term investment policy tells a firm how to hold surplus cash: safety first, then liquidity, then yield. Instruments include T-bills, commercial paper, CDs, repos and money market funds. You solve questions by matching the instrument's credit risk, liquidity and yield to the stated policy objective and ranking them.

Understand Short-Term Investment Policy and Instruments

A company often holds cash it does not need today. Short-term investment policy sets the rules for where that cash can go. It is usually written down in an investment policy statement (IPS) that covers the purpose of the portfolio, the risk limits, the allowed instruments and who approves exceptions.

The usual objective order is safety of principal, then liquidity, then yield. A treasurer is not paid to take credit risk with cash that must fund payroll or a debt payment next month. So the IPS typically limits issuer credit quality, maturity, concentration in one issuer and the types of instruments allowed.

The main instruments sit on a spectrum. Treasury bills are government securities with maturities of one year or less, issued at a discount, with very low credit risk and the deepest liquidity, so they offer the lowest yield. Commercial paper is unsecured short-term debt issued by large, creditworthy corporations, also at a discount, usually with maturities of up to about 270 days in the US. It typically yields more than T-bills because it carries credit risk and is less liquid. Certificates of deposit (CDs) are bank deposits with a fixed term and rate. Negotiable CDs can be sold before maturity, but non-negotiable CDs usually carry a penalty for early withdrawal. Repurchase agreements are short-term loans collateralized by securities. Money market funds pool investors' cash into a diversified portfolio of these instruments, giving instant diversification and daily liquidity but charging a fee.

Yield differences follow risk. T-bills usually sit at the low end of the yield range because they have the least credit risk and the deepest liquidity. Commercial paper typically yields more than T-bills. The exact order among repos, bank CDs, money market funds and commercial paper depends on issuer credit quality, collateral, maturity and market conditions, so there is no fixed ranking among them. The logic holds: more credit risk, less liquidity or a longer maturity means a higher yield.

The exam tests whether you can pick the instrument that fits a stated policy, recognise which instrument is discount-based, and judge trade-offs. It also tests whether you know that chasing yield breaks a safety-first policy.

Key formulas to remember

Policy priority order: Safety of principal > Liquidity > Yield; Default order for corporate short-term cash. If a question states different priorities, follow the question.
Discount-basis pricing: Price = Face value × (1 − Discount rate × Days ÷ 360); Used for T-bills and commercial paper quoted on a bank discount basis. Uses a 360-day year.
Holding period yield: HPY = (Face value − Price) ÷ Price; Return earned over the life of the instrument, measured on the price paid.
Money market yield: MMY = HPY × (360 ÷ Days); Annualizes on a 360-day year without compounding.
Bond equivalent yield: BEY = HPY × (365 ÷ Days); Annualizes on a 365-day year without compounding; comparable with bond yields.
Yield ranking logic: More credit risk + less liquidity + longer maturity = higher yield; Use this to rank T-bills, CDs and commercial paper.

How to solve Short-Term Investment Policy and Instruments questions

Use this method for any question on short-term investment policy or instruments.

1Read the stem and find the stated objective: safety, liquidity, yield, or a mix. Note any limits on maturity, rating or issuer.
2Identify each instrument and its issuer: government, bank or corporation.
3Rank the options by credit risk and liquidity. T-bills are safest and most liquid.
4Remove any option that breaks a stated policy limit, such as a rating floor or a maturity cap.
5If the question asks for a yield ranking, apply: more risk and less liquidity means a higher yield.
6If a calculation is needed, use HPY first, then annualize with 360 or 365 as the question asks.
7Choose the option that best meets the top-priority objective, then check that it does not violate any constraint.

Quickest way: Safety-liquidity-yield screen

When to use it: Use when the question asks which instrument suits a policy or which one yields most or least.

Underline the top priority word in the stem.
Rank the three options on risk from lowest to highest.
If safety or liquidity leads, pick the lowest-risk option that meets the limits.
If yield leads, pick the highest-yielding option that still meets the limits.
For numbers, compute HPY and multiply by 360 ÷ days or 365 ÷ days.

Common mistakes in Short-Term Investment Policy and Instruments

Choosing the highest-yielding instrument for a safety-first policy.
Yield looks like the obvious goal, so candidates forget the priority order.
Fix: Find the stated objective first. Eliminate options that add credit or liquidity risk beyond the policy.
Treating commercial paper as secured or government-backed.
Its short maturity makes it feel safe.
Fix: Remember that commercial paper is unsecured corporate debt. It carries credit risk and yields more than T-bills.
Using the discount rate as the actual return.
Discount rate and yield sound alike.
Fix: The discount rate is based on face value. Compute the price, then HPY on price. The yield is higher than the discount rate.
Mixing 360-day and 365-day year conventions.
Both appear in money market and bond-equivalent calculations.
Fix: Money market yield uses 360. Bond equivalent yield uses 365. Check which the question requests.
Assuming all CDs can be sold before maturity.
Candidates mix up negotiable and non-negotiable CDs.
Fix: Only negotiable CDs trade in a secondary market. Non-negotiable CDs normally carry an early withdrawal penalty.
Assuming a money market fund guarantees principal.
Funds aim for a stable value and hold safe assets.
Fix: Funds are diversified and liquid, but they are not guaranteed. They also charge fees that reduce yield.

Worked examples

Example 1

A treasurer buys a 90-day T-bill with face value $1,000,000 at a price of $990,000. What is the money market yield? A) 3.03% B) 4.04% C) 4.10%

Show the solution

HPY = (1,000,000 − 990,000) ÷ 990,000 = 0.010101.
MMY = HPY × (360 ÷ 90) = 0.010101 × 4.
MMY = 0.040404, or 4.04%.
The bank discount rate is (10,000 ÷ 1,000,000) × (360 ÷ 90) = 4.00%. The money market yield of 4.04% is higher because HPY is measured on the price paid, not on face value.
The 3.03% option is an incorrect distractor. It is what you get if you multiply HPY by 3 instead of 4, for example by using a 120-day bill's factor (360 ÷ 120 = 3) for a 90-day bill.
The 4.10% option is the 365-day bond equivalent yield (0.010101 × 365 ÷ 90 = 4.097%). It is a different measure from the money market yield the question asks for.

Answer: B) 4.04%

Example 2

A firm's IPS requires safety of principal first, then liquidity, then yield. Which instrument is most appropriate for cash needed in 60 days? A) Commercial paper from a highly rated issuer B) A 60-day government T-bill C) A non-negotiable 12-month bank CD

Show the solution

The top priority is safety, then liquidity. Yield comes last.
Option A is unsecured corporate debt. Even with a high rating it carries more credit risk and is less liquid than a government bill. It loses to a safer option on the top priority.
Option C has a 12-month term, which is far longer than the 60-day need. Because it is non-negotiable, cashing it in early normally costs an early withdrawal penalty, which puts principal and liquidity at risk. Eliminate it.
Option B has the lowest credit risk, the deepest liquidity and matures at the 60-day horizon. It best meets safety first, then liquidity.

Answer: B) A 60-day government T-bill

Exam tips

Read the priority order in the stem. Most wrong answers fail because they chase yield or ignore a stated limit.
Remember the risk logic: T-bills sit at the low-yield end, and commercial paper typically yields more than T-bills. The order among CDs, repos and commercial paper depends on issuer credit quality and market conditions, so rely on the stem's details.
Check the day-count convention before annualizing: 360 for money market yield, 365 for bond equivalent yield.
Watch for the phrase unsecured, negotiable or discount basis. These words decide which option is correct.
For three-option MCQs, remove the option that breaks a constraint first. Then compare the remaining two on risk and liquidity.

Practice questions from Working Capital and Liquidity

Short-Term Investment Policy and Instruments in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Short-Term Investment Policy and Instruments: frequently asked questions

What is the difference between commercial paper and Treasury bills?

T-bills are issued by a government and carry very low credit risk. Commercial paper is unsecured debt issued by corporations, so it carries credit risk and normally yields more. Both are sold at a discount and mature in the short term.

What are the main objectives of a short-term investment policy?

The usual order is safety of principal, liquidity, then yield. The policy also sets limits on issuer quality, maturity, concentration and allowed instruments. These limits are written in the IPS.

Are money market funds risk-free?

No. They hold diversified short-term instruments and offer daily liquidity, but they are not guaranteed and they charge fees. Their yield is usually lower than direct holdings of the same assets because of those fees.

How do I convert a T-bill discount into a yield?

Find the price from the discount rate, then compute HPY as (face value − price) ÷ price. Multiply by 360 ÷ days for money market yield or 365 ÷ days for bond equivalent yield. On a BA II Plus, just do the arithmetic directly with the chain calculation.