Commercial paper

Definition

Commercial paper is a short-term, unsecured promissory note issued by corporations to raise funds for working capital and other short-term needs. It is typically issued at a discount and has maturities that range from a few days to up to 270 days, providing companies with quick access to cash without the need for collateral or lengthy approval processes. This financial instrument is a vital component of short-term financing strategies and plays a significant role in managing cash and marketable securities effectively.

5 Must Know Facts For Your Next Test

1. Commercial paper is usually issued by large, financially stable corporations with high credit ratings, making it an attractive option for investors looking for low-risk investments.
2. The interest rates on commercial paper are generally lower than those of bank loans, making it a cost-effective alternative for companies needing short-term funding.
3. Because commercial paper is unsecured, it relies heavily on the issuing company's creditworthiness; thus, companies with better credit ratings can issue it at lower rates.
4. Commercial paper can be sold directly to investors or through dealers, allowing for flexibility in how corporations manage their funding needs.
5. Investors in commercial paper typically include money market funds, institutional investors, and corporations seeking a safe place to park cash temporarily.

Review Questions

• How does commercial paper provide advantages over traditional bank loans for corporations seeking short-term financing?
  • Commercial paper offers several advantages over traditional bank loans. It typically has lower interest rates due to the lack of collateral requirements and the strong credit ratings of issuers. Additionally, the issuance process is quicker and more flexible, allowing companies to access funds rapidly without lengthy approval processes. This makes commercial paper an attractive option for businesses that require immediate liquidity for operational needs.
• Evaluate the risks associated with investing in commercial paper compared to other short-term investment options.
  • Investing in commercial paper carries specific risks primarily associated with the issuing company's creditworthiness since it is an unsecured instrument. If a company faces financial distress or defaults, investors may not recover their investments. Compared to options like treasury bills or highly-rated municipal bonds, which are backed by government guarantees or taxes, commercial paper is riskier. Therefore, investors must assess the issuing company’s credit rating before committing their funds.
• Analyze how fluctuations in interest rates could impact the commercial paper market and corporate financing strategies.
  • Fluctuations in interest rates can significantly influence the commercial paper market by altering borrowing costs for corporations. When interest rates rise, companies may find it more expensive to issue commercial paper compared to other financing options. This can lead them to rely more on longer-term debt instruments or bank loans. Conversely, when rates are low, issuing commercial paper becomes more attractive, encouraging companies to take advantage of cheaper funding for their operational needs. Understanding these dynamics helps corporations strategically manage their financing mix based on market conditions.

Related terms

liquidity: Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its price.

credit rating:

A credit rating is an evaluation of the creditworthiness of a borrower, assessing their ability to repay debt and indicating the level of risk associated with lending to them.

commercial paper market: The commercial paper market is a segment of the money market where corporations issue and investors purchase short-term unsecured debt instruments.