Commercial Paper Definition

Commercial Paper is defined as a money market instrument that is used for

obtaining short-term funding and is usually in the form of a promissory
note issued by investment grade banks and corporations. Most commercial
papers are easily rolled over by paying for old issuance from the proceed of
new issuances, hence it becomes a continuous source of funding.
 Investments in such securities are done by institutional investors and
high net worth individuals (HNI) directly & by others through mutual funds
or exchange-traded fund (ETF).
 It is not meant for the general public and hence, there is a restriction
on the advertisement to market the securities. A secondary market also
exists for commercial papers but the market players are mostly financial
institutions.
 It is issued at a discount to the face value and upon maturity, the face
value becomes the redemption value. It is issued in large denominations,
for e.g. $100,000.
 The maturity of commercial paper ranges from 1 to 270 days (9
months) but usually, it is issued for 30 days or less. Some countries also
have a maximum duration of 364 days (1 year). Higher the duration, higher
is the effective rate of interest on these papers.
 There is no need to register the papers with the Securities Exchange
Commission (SEC) and hence, it helps in saving the administrative expenses
and results in lesser filings.

 Code – UCC)
As per the Uniform Commercial Code (UCC), commercial papers are of four
kinds:
1. Draft – A draft is a written instruction by a person to another to pay
the specified amount to a third party. There are 3 parties in a draft. The
person who gives the instructions is called “drawer”. The person who is
instructed is called “drawee”. The person who has to receive the payment is
called “payee”.
2. Check – This is a special form of the draft where the drawee is a bank.
There are certain special rules which apply on a check, hence this is
considered to be a different instrument.
3. Note – In this instrument, a promise in made by one person to pay
another a certain sum of money to another. There are 2 parties in a note.
The person who makes the promise and writes the instrument is called
“drawer” or “maker”. The person to whom the promise is made and to
whom payment is to be made is called “drawee” or “payee”. It is also known
as “promissory note”. In most of the instance, a commercial paper is in the
form promissory note.
4. Certificates of Deposit (CD) – A CD is an instrument wherein the
bank acknowledges the receipt of deposit. Further, it also carries details
about maturity value, interest rate, and maturity date. It is issued by the
bank to the depositor. It is a special form of the promissory note. There are
certain special rules which apply on CD, hence this is considered to be a
different instrument.
)
On the basis of security, there are two types of commercial papers:
1. Unsecured Commercial Papers – These are also known as traditional
commercial papers. Most of these papers are issued without any collateral
and hence, they are unsecured. The rating of the issue depends upon the
asset quality and all other aspects relating to that organization. Rating is
done in the same manner in which it is done for the bonds. These are not
covered by the deposit insurance, for e.g. Federal Deposit Insurance
Corporation (FDIC) insurance in the U.S. and hence, investors obtain
insurance from the market separately, as a backup.
2. Secured Commercial Papers – These are also known as Asset-
backed commercial papers (ABCP). These are collateralized by other
financial assets. These are normally issued by creating a Structured
Investment vehicle that is set up by the sponsoring organization by
transferring certain financial assets. These papers are issued to keep off the
instruments from the financial statement of the sponsor organization.
Further, the rating agencies rate the issue on the basis of the assets kept in
the Structured Investment Vehicle, ignoring the asset quality of the
sponsor. During the financial crisis, ABCP holders were one of the biggest
loss-makers.

 e Yield of Commercial Paper

Formula for Yield Commercial Paper:

Example
Calculate the interest yield of the following commercial paper:

Solution:
 Brokerage = 3% of $500,000 = $15,000
 Net Sale Price = $495,000 – $15,000 = $475,000
The calculation for Yield is as follows –
 Yield = [(Face Value – Sale Price)/Sale Price] * (360/Maturity Period) *
100
 = (500,000 – 475,000)/475,000 * (360/100) * 100
 = 18.95%

 
Pricing of Commercial Paper
Formula for Pricing Commercial Paper:

Commercial Paper Example

Calculate the market price of the following example of commercial paper:

Solution:
The calculation for Pricing is as follows –

 Price = Face Value / [1+{(Yield/100)*(Maturity Period/360)}]

 = 600,000 / [1+(20/360)]
 = $568,421

 
Advantages
1. No collateral is needed.
2. Lower cost of funding.
3. Lesser documentation and compliance.
4. Highly liquid.
5. It allows the diversification of funds in short-term instruments.
6. High-rated instruments, hence fewer chances of default.
7. For investors, returns are higher as compared to bank deposits.
8. No restriction on the end-use of funds.

 
Disadvantages
1. Commercial paper can be issued by investment-grade banks and
large corporations only, hence it is not a source of fund which is available
to all.
2. Small investors cannot directly invest in commercial paper.
3. Secondary market for commercial papers is less liquid.

 
Latest trends
 The commercial paper market stood at $7.2 billion for the financial
sector and $23 billion for the non-financial sector as on April 2019 month
end as per Fed reserve.
 Most of the issuances are done in 1-4 days bracket as per Fed
reserve. A total of 112 issues were done in April 2019 and out of those, 47
issues were related to 1-4 days bracket.
 Interest rates during April 2019 were ranging from 2.39% to 2.47% for
institutions with AA rating and 2.46% to 2.56% for others as per Fed
reserve.
 Commercial paper market is growing and most of the investments
are through prime money market funds (MMF).

 
Conclusion
Commercial paper is a negotiable instrument issued to get short-term
credit. There are certain rules and restrictions on issuances, issuers, and
investors. It is usually unsecured but at times, backed by financial assets.
The discount at which the instrument is issued results in the rate of return
on commercial paper.
After the 2008 crisis, investors lost their confidence in this instrument,
particularly asset-backed ones, but the same has now been restored. As a
result, these papers are widely issued and invested in.
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