Define Commercial Paper

Commercial Paper

What Is Commercial Paper and How Does It Work?

Commercial paper is a sort of unsecured, short-term financial instrument issued by businesses that is often used to fund payroll, accounts payable, and inventory, as well as satisfy other short-term obligations. On commercial paper, maturities generally last a few days and seldom exceed 270 days.

Commercial paper is frequently sold at a discount to its face value, reflecting current market interest rates.

TAKEAWAYS IMPORTANT

Commercial paper is a type of unsecured, short-term debt that businesses use to fund payrolls, payables, inventory, and other short-term obligations.

Most commercial papers have maturities ranging from a few weeks to months, with an average of roughly 30 days.

Commercial paper is frequently offered at a discount without the payment of coupons and matures at face value, which reflects current interest rates.

Commercial Paper: An Introduction

Over 150 years ago, New York merchants began selling their short-term responsibilities to dealers who functioned as intermediaries in order to free up funds to pay near-term obligations. As a result, these dealers would buy the notes at a lower price than their face value and then sell them to banks or other investors. Following that, the borrower would return the investor a sum equal to the note's par value. 1

Commercial paper is unsecured debt since it is not generally backed by any kind of collateral. It is not to be confused with asset-backed commercial paper (ABCP), which is a type of financial instrument backed by assets chosen by the issuer. Commercial paper is only issued by companies with high-quality debt ratings in either situation. Only these types of businesses will be able to find purchasers without having to provide a significant reduction (a higher price) for the debt.

Commercial paper is issued by major organisations, hence the denominations are huge, generally $100,000 or more. Commercial paper is typically purchased by other firms, financial institutions, rich people, and money market funds.

Marcus Goldman of Goldman Sachs was the first money market dealer to buy commercial paper, and his firm grew to be one of America's largest commercial paper dealers after the Civil War. 2

Commercial Paper's Benefits

Commercial paper has the advantage of not requiring registration with the Securities and Exchange Commission (SEC) as long as it matures within nine months, or 270 days, making it a particularly cost-effective method of financing. Although maturities can be as long as 270 days before coming under the SEC's jurisdiction, commercial paper maturities are often less than 30 days. 

The funds from this sort of financing may only be spent on current assets, such as inventory, and cannot be used on fixed assets, such as a new plant, without the approval of the Securities and Exchange Commission.

During the Financial Crisis, Commercial Paper

In the financial crisis that began in 2007, the commercial paper market played a significant role. The commercial paper market froze as investors began to distrust the financial health and liquidity of corporations like Lehman Brothers, and enterprises were no longer able to receive simple and inexpensive finance. Another consequence of the commercial paper market's halt was the "breaking of the buck" by several money market funds, who were significant commercial paper investors. As a result, the impacted funds' net asset values were below $1, indicating the declining value of the dollar.

A outstanding commercial debt issued by companies with questionable financial condition. 4

As a result of the credit constraint encountered by financial intermediaries in the commercial paper market, the Federal Reserve Bank of New York established the Commercial Paper Funding Facility (CPFF) on Oct. 7, 2008. The CPFF was terminated by the Federal Reserve Bank of New York in February 2010 because it was no longer needed as the banking industry and the broader economy recovered. 5

Commercial Paper as an Example

When a retailer needs short-term borrowing to finance new inventory for the forthcoming Christmas season, commercial paper is one option. The company need $10 million and is offering investors $10.1 million in commercial paper face value in return for $10 million in cash, based on current interest rates.

In exchange for the $10 million in cash, a $0.1 million interest payment would be made at maturity of the commercial paper, corresponding to a 1% interest rate. This interest rate can be changed over time based on how long the commercial paper has been outstanding.