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 made by institutional investors and high net worth individuals (HNI) directly & by others through mutual funds or exchange-traded funds (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, 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). The higher the duration, the 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.
Types of Commercial Paper (Uniform Commercial Code – UCC)
As per the Uniform Commercial Code (UCC), commercial papers are of four kinds:
- 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 the “payee.”
- Check – This is a special form of the draft where the drawee is a bank. There are certain special rules which apply to a check. Hence this is considered to be a different instrument.
- Note – In this instrument, a promise is 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 instances, a commercial paper is in the form promissory note.
- 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 to a CD. Hence this is considered to be a different instrument.
Types of Commercial Papers (On The Basis of Security)
On the basis of security, there are two types of commercial papers:
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- 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, e.g., Federal Deposit Insurance Corporation (FDIC) insurance in the U.S., and hence, investors obtain insurance from the market separately as a backup.
- 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.
Calculate Yield of Commercial Paper
Formula for Yield Commercial Paper:
Yield = (Face Value – Sale Price/ Sale Price) * (360/Maturity Period) * 100
Example
Calculate the interest yield of the following commercial paper:
- Face Value: $500,000
- Sale Price: $490,000
- Maturity period: 100
- Brokerage and Other charges: 3%
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:
Price = Face Value / [1+(Yield/100 * Maturity Period/360)]
Commercial Paper Example
Calculate the market price of the following example of commercial paper:
- Face Value: $500,000
- Yield (after brokerage): 20%
- Maturity period: 100
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
- No collateral is needed.
- Lower cost of funding.
- Lesser documentation and compliance.
- Highly liquid.
- It allows the diversification of funds in short-term instruments.
- High-rated instruments, hence fewer chances of default.
- For investors, returns are higher as compared to bank deposits.
- No restriction on the end-use of funds.
Disadvantages
- 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.
- Small investors cannot directly invest in commercial paper.
- The 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 of April 2019 month end as per Fed reserve.
- Most of the issuances are done in a 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.
- The 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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