Definition
Commercial Papers are short-term, unsecured promissory notes issued by corporations with high credit ratings. They are typically used to finance short term liabilities such as accounts payable and inventory. These instruments are typically issued at a discount and have maturities that do not exceed 270 days.
Key Takeaways
- Commercial Papers are short-term unsecured promissory notes issued by corporations to raise capital for immediate financial needs. Typically, they have a maturity period of up to 270 days.
- Due to their short-term nature, they do not require a registration with the Securities and Exchange Commission (SEC) if their maturity is no more than 270 days, making them a cost-efficient way for companies to raise funds.
- Commercial Papers are often purchased by money market funds, and other institutional investors. But they are not FDIC-insured, meaning they are not guaranteed by the government. Thus, they are considered a higher-risk investment than other short term investments such as Treasury bills.
Importance
Commercial Papers are crucial in the world of finance as they provide a cost-effective means for large corporations to obtain short-term funding for their operational needs.
Commercial papers are unsecured, short-term debt instruments issued by corporations, typically for the financing of accounts payable, inventories, and meeting short-term liabilities.
They are an alternative to loans and often preferred by corporations because they generally offer lower interest rates and don’t have the collateral requirements that come with traditional bank loans.
Additionally, they give investors the option to keep their money invested for a shorter time period – with maturity typically ranging from 1 to 270 days – thus allowing quick returns and limiting exposure to long-term risks.
Hence, commercial papers are an essential part of the corporate finance landscape.
Explanation
Commercial papers serve a critical function in the short-term funding needs of major corporations. Effectively, they are unsecured promissory notes or debt instruments issued by corporations with excellent credit ratings.
The intention isn’t to fund long-term investment but instead to cover short-term liabilities, such as payroll and other immediate operational costs. Proceeds from the issuing of commercial papers are used to finance current operations and meet short-term obligations, making them an integral part of everyday financial management for many firms.
These instruments essentially offer a viable alternative to bank loans, which may not be attractive options due to higher interest rates or regulatory complications. Commercial papers generally have a much lower cost of capital compared to bank loans, thereby making it an attractive option for companies.
Investors, meanwhile, find commercial papers attractive due to their short-term nature, often maturing in less than nine months, and offering slightly higher returns compared to government securities. Thus, the commercial paper market enables a mutually beneficial setup where companies can secure much-needed funds for operations, while investors get to invest their money in a relatively low-risk instrument with decent returns.
Examples of Commercial Papers
In 2008, during the financial crisis, the Lehman Brothers’ collapse led to investors losing faith in its commercial paper, which significantly led to the firm’s downfall. The commercial paper issued by Lehman Brothers had become risky for buyers, causing a significant drop in sales and leading to liquidity problems for the company, leading to their eventual bankruptcy.
Toyota Motor Credit Corporation, the financial arm of the international car manufacturing company, Toyota, frequently issues commercial papers to finance their short-term operational needs. As the financial subsidiary of a reputable, multinational company, TMCC’s commercial papers are considered low-risk by investors.
In 2019, Reliance Industries Limited – an Indian multinational conglomerate company headquartered in Mumbai – issued two types of commercial paper. These were for ₹500 crore with a coupon rate of
03%, and for ₹1,500 crore with a coupon rate of
11%. The company used the funds to finance its regular business operations.
FAQs on Commercial Papers
What are Commercial Papers?
Commercial Papers are a short-term financial instrument that is unsecured and used by corporations to finance short-term liabilities. They are issued at a discount and have a fixed maturity of up to 270 days.
Who can issue Commercial Papers?
Commercial Papers can be issued by highly rated corporate borrowers, financial institutions, and other corporations with high-quality debt ratings.
Who buys Commercial Papers?
Commercial Papers are typically bought by money market funds, mutual funds, and other investors seeking short-term investment opportunities. They are sold at a discount and redeemed at face value on maturity, offering a yield to the investor.
What are the advantages of investing in Commercial Papers?
Commercial Papers offer higher returns compared to other short-term instruments such as Treasury Bills. They are considered to be a low risk investment due to their short maturity and high creditworthiness of the issuers.
What are the disadvantages or risks associated with Commercial Papers?
The primary risk for investors in Commercial Papers is the default risk if the issuer fails to pay the investment amount upon maturity. In addition, Commercial Papers are not FDIC insured and have no secondary market, meaning they can be illiquid.
Related Entrepreneurship Terms
- Short-Term Unsecured loans
- Maturity
- Discount Rate
- Liquidity
- Credit Rating
Sources for More Information
- Investopedia: This source provides definitions and comprehensive explanations of various investment terms, including Commercial Papers. You can find plenty of articles and guides on this topic in their extensive financial library.
- U.S. Securities and Exchange Commission: The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisers, and mutual funds. Their site contains substantial information about Commercial Papers.
- Federal Reserve: The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system. They offer resources on various financial products, including Commercial Papers.
- Financial Times: It is one of the world’s leading news organisations, recognised internationally for its authority, integrity, and accuracy. The site offers comprehensive news and articles about Commercial Papers and other finance related topics.
