Commercial paper benefits public limited companies because it allows them access to a fast and short-term source of financing. There is also an investing public that enjoys these advantages, since it can be a way to obtain higher dividends than those offered by banks.
It is not usually backed by any type of warranty. As a result, only those companies with high-quality debt ratings in the market will find buyers quickly.
Otherwise, the company must attract the buyer by giving him the lure of a higher percentage of profit at a substantial discount.
Characteristics
Commercial paper is a short-term unsecured debt instrument issued by a public limited company. It is commonly issued to finance inventories, accounts receivable, and to meet short-term debts.
The return to investors is based on the difference between the sale price and the purchase price. Commercial paper offers a different alternative for attracting resources to those already traditionally offered by the banking system.
Maturities of commercial paper rarely go beyond 270 days. It is generally issued at a discount from its nominal value, reflecting current market interest rates.
Because commercial paper is issued by large institutions, the denominations of commercial paper offerings are substantial, typically $ 100,000 or more.
Buyers of commercial papers are generally corporations, financial institutions, wealthy individuals, and money market funds.
Commercial paper and Treasury bond
Commercial paper is not as liquid as Treasuries because it does not have an active secondary market. Therefore, investors who buy commercial papers usually plan to hold them until maturity, as it is short-term.
Because the company that issued the commercial paper is likely to default on its payment at maturity, investors require a higher return on commercial paper than they would receive for a risk-free security, such as a Treasury bond, with a similar maturity.
Like Treasuries, commercial paper makes no interest payments and is issued at a discount.
Types
Drafts or bills of exchange
A draft is an unconditional order written by one person (the drawer) that directs another person (the drawee) to pay a specified amount of money, on a specific date, to a named third person (the payee). The draft is a three-way transaction.
It is called a bank draft if it is made in a bank; if it is carried out elsewhere, it is called a business turn. A draft is also called a bill of exchange, but while a draft is negotiable or endorsable, this is not true for a draft.
Drafts are used primarily in international trade. They are a kind of check or note without interest. The spins can be divided into two broad categories:
Turn in sight
It requires that the payment be made when presenting it at the bank.
Forward draft
Demand payment on the specified date.
Promissory notes
They correspond to a financial instrument that consists of a promise or written commitment by one of the parties (the issuer) to pay another party (the beneficiary) a specified amount of money on a specific future date.
The issuer could execute a promissory note in exchange for a monetary loan from a financial institution, or in exchange for the opportunity to make a purchase on credit.
Financial institutions are empowered to issue them. They can also be generated by companies in order to obtain financing from a non-bank source.
Checks
It is a special form of spin. A check is defined as a draft drawn on a bank and payable on demand.
It is a document issued by a drawer for a financial institution to cancel the amount expressed in it to another person or beneficiary, provided that the account against which the check is drawn has funds.
The beneficiary demands payment from the bank, but not from the drawer or any previous endorser of the check.
Deposit certificates
It is a financial document in which a bank recognizes that it received an amount of money from a depositor for a period of time and a specific interest rate, and agrees to return it at the time specified in the certificate.
The bank is the drawer and the drawee, while the individual making the deposit is the beneficiary.
Because certificates of deposit are negotiable, they can be easily negotiated if the holder wants the cash, although its price fluctuates with the market.
Examples 2007 North American financial crisis
The commercial paper market played an important role in the North American financial crisis that began in 2007.
When investors began to doubt the financial health and liquidity of firms like Lehman Brothers, the commercial paper market froze and companies were no longer able to access easy and affordable financing.
Another effect of the commercial paper market freeze was that of some money market funds, which were major investors in commercial paper, "breaking the dollar."
This meant that the affected funds had net asset values below $ 1, reflecting the declining value of their exceptional commercial papers issued by companies in suspicious financial health.
Company example
The retailer Toys CA is seeking short-term financing in order to finance new inventory for the holiday season.
The company needs $ 10 million and offers investors $ 10.2 million in the face value of the commercial paper in exchange for $ 10 million, based on prevailing interest rates.
In effect, there would be an interest payment of $ 200,000 at maturity on the commercial paper in exchange for the $ 10 million in cash, which equates to an interest rate of 2%.
This interest rate can be adjusted depending on the number of days that the commercial paper is in circulation.
