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 financial needs. It typically has maturities ranging from a few days to up to 270 days and is often used by businesses as a means of financing their operational expenses without having to resort to bank loans or other credit facilities.

5 Must Know Facts For Your Next Test

1. Commercial paper is typically issued at a discount to face value, allowing investors to earn a return upon maturity when the issuer repays the full face value.
2. Large, creditworthy corporations usually issue commercial paper, making it a popular choice among institutional investors looking for low-risk short-term investments.
3. Investors are attracted to commercial paper due to its liquidity and the potential for higher yields compared to other short-term investments like Treasury bills.
4. The market for commercial paper can be sensitive to changes in interest rates and economic conditions, as issuers may find it harder to roll over maturing papers in times of financial stress.
5. Regulatory guidelines limit the maximum maturity of commercial paper to 270 days, making it distinct from longer-term debt instruments.

Review Questions

• How does commercial paper differ from other forms of short-term financing available to corporations?
  • Commercial paper stands out from other short-term financing options like bank loans or lines of credit due to its unsecured nature and typically lower interest rates. While bank loans often require collateral and involve a more lengthy approval process, commercial paper can be issued quickly with minimal documentation. This allows companies to access funds rapidly, making it an attractive option for managing immediate cash flow needs.
• Discuss the factors that influence the interest rates on commercial paper and how they relate to market conditions.
  • Interest rates on commercial paper are influenced by several factors including the creditworthiness of the issuing corporation, prevailing interest rates in the economy, and overall market demand for short-term securities. If the economy is strong and investor confidence is high, issuers can often secure lower rates due to increased demand. Conversely, during economic downturns or when credit risk rises, rates tend to increase as investors require higher returns for perceived risks.
• Evaluate the impact of regulatory guidelines on the commercial paper market and how they shape issuer behavior.
  • Regulatory guidelines significantly influence the commercial paper market by setting limits on maturity periods and requiring that issuers maintain certain credit ratings. These regulations help ensure that only financially stable companies participate in this market, fostering investor confidence. Consequently, firms are incentivized to maintain strong credit ratings and manage their financial health carefully in order to access this crucial source of short-term funding without excessive costs.

Related terms

Promissory Note: A financial instrument in which one party makes a written promise to pay a specified sum of money to another party at a future date.

Money Market: A sector of the financial market where short-term borrowing and lending occur, typically involving instruments like treasury bills, commercial paper, and certificates of deposit.

Credit Rating: An assessment of the creditworthiness of a borrower in general terms or regarding a particular debt or financial obligation, which can affect the interest rates on commercial paper.