Definition

An unsecured short-term debt instrument which is issued by corporations is called commercial paper.

Description

Commercial paper was first used during colonial times and was known as a bill of exchange. They became more modern in the 1920s, when New York merchants began selling their short-term commitments to dealers in order to obtain the capital required to pay near-term obligations. 

These traders, or middlemen, paid a lower price than the par value for the paper (also known as promissory notes). They subsequently sold the paper to banks and other investors. The merchants would reimburse the investors the par value of the note.

• Companies typically issue commercial paper to cover wages, payables, inventories, and other short-term needs.
• The maturities of commercial paper range from one to 270 days, with an average of roughly 30.
• Commercial paper is issued at a discounted rate and matures at the face value.
• The minimum denomination of commercial paper is $100,000, and it pays a set interest rate that varies with the market.

Advantages of Commercial Paper
 

• Commercial paper has the advantage of being able to be registered with the Securities and Exchange Commission (SEC) as long as it matures in no more than nine months (270 days).
• This makes it a low-cost and simple method of funding. Although maturities for commercial paper can be as long as 270 days before being subject to SEC oversight, they typically last about 30 days.
• Commercial paper is also less time-consuming and less expensive than obtaining a business loan.
• It provides issuers with cheaper interest rates while offering investors a reduced default risk.
• Commercial paper is an efficient strategy for investors to diversify their holdings.

Difference between commercial paper and certificate of deposit
 

What are the features of commercial paper?
 

1. Issued at a discount: Commercial papers are typically issued at a discount to their face value, and investors receive the face value upon maturity, thus earning a return on their investment.
2. Large denominations: They are usually issued in large denominations, making them more suitable for institutional investors than individual retail investors.
3. Flexible maturity: One of the critical advantages of commercial papers is their ability to be tailored to the specific funding needs of the issuer. This flexibility is a significant draw for those managing short-term cash flow requirements.
4. Regulated: It's important to note that commercial papers are subject to stringent regulation by financial authorities like the Securities and Exchange Board of India (SEBI). This oversight ensures transparency and safeguards the interests of investors.
5. Secondary market trading: While commercial papers are typically held until maturity, they can be traded in the secondary market before maturity, providing liquidity to investors. However, liquidity in the secondary market may be limited compared to other securities.

Example

General Electric (GE) is a well-known example of a company that issues commercial paper to meet its short-term financing requirements.

FAQ

What is the commercial paper market?

The commercial paper market is a short-term debt market in which enterprises and financial institutions issue unsecured promissory notes to raise capital for their short-term financing requirements.

What is commercial paper minimum amount?

The minimum investment amount for commercial paper varies according to the issuer and market conditions. However, it is usual for commercial papers to have significant minimum investment requirements, which can range from several lakhs to crores of rupees.

CPs can be issued in values of Rs. 5 lakh or multiples thereof. A single investor should invest at least Rs. 5 lakh (face value).

This makes commercial papers more appealing to institutional investors than individual retail investors. Before investing in commercial paper, investors should consult with the issuer or their financial advisor to determine the exact minimum investment requirements.