Commercial Paper

Definition

Commercial paper is a type of unsecured, short-term debt instrument issued by corporations and other entities to finance their short-term operational needs. It serves as a flexible and cost-effective way for companies to raise funds in the money market.

5 Must Know Facts For Your Next Test

1. Commercial paper is typically issued by large, creditworthy corporations, financial institutions, and government entities to meet their short-term financing needs, such as funding payroll, inventory, or accounts payable.
2. The maturity of commercial paper ranges from 1 to 270 days, with the most common maturities being 30 days or less, allowing companies to match their financing needs with their cash flow cycles.
3. Commercial paper is generally considered a low-risk investment because issuers are typically highly creditworthy, and the short-term nature of the instrument reduces the risk of default.
4. The interest rate on commercial paper is typically lower than the interest rate on bank loans, making it an attractive financing option for companies.
5. Commercial paper is an important component of the M2 money supply, as it represents a highly liquid and readily available source of short-term funding for businesses.

Review Questions

• Explain how commercial paper is used by corporations to finance their short-term operational needs.
  • Commercial paper is a popular financing tool for corporations because it allows them to raise funds quickly and cost-effectively to meet their short-term cash flow requirements, such as paying for inventory, meeting payroll, or settling accounts payable. By issuing commercial paper, companies can access the money market and obtain financing at lower interest rates than traditional bank loans, making it a flexible and efficient way to manage their short-term liquidity needs.
• Describe the relationship between commercial paper and the M2 money supply.
  • Commercial paper is an important component of the M2 money supply, which is a broader measure of the money supply that includes not only currency and demand deposits (M1), but also other highly liquid assets such as savings deposits, money market mutual funds, and short-term time deposits. As commercial paper represents a readily available and liquid source of short-term funding for businesses, it is included in the M2 money supply, reflecting its role in the overall money market and its potential impact on the broader economy.
• Analyze the factors that contribute to the low-risk nature of commercial paper and its appeal as an investment.
  • Commercial paper is generally considered a low-risk investment for several reasons. Firstly, the issuers of commercial paper are typically large, creditworthy corporations, financial institutions, or government entities, which reduces the risk of default. Secondly, the short-term maturity of commercial paper, typically 1 to 270 days, limits the exposure to interest rate and market fluctuations. Additionally, commercial paper is a highly liquid instrument, meaning it can be easily bought and sold in the money market, providing investors with the flexibility to access their funds quickly. These factors, combined with the typically lower interest rates compared to other short-term debt instruments, make commercial paper an attractive investment option for investors seeking a low-risk, liquid, and cost-effective way to deploy their short-term funds.

Related terms

Money Market: The money market is a financial market that deals in short-term debt instruments, such as commercial paper, Treasury bills, and certificates of deposit. It provides a platform for the issuance and trading of these liquid, low-risk securities.

Unsecured Debt: Unsecured debt refers to loans or debt instruments that are not backed by any collateral. Commercial paper is an example of unsecured debt, as it is not secured by any physical assets or guarantees.

Liquidity:

Liquidity refers to the ease with which an asset can be converted into cash. Commercial paper is considered a highly liquid instrument because it can be easily bought and sold in the money market.