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Commercial Paper



Definition

Commercial Paper is a short-term unsecured promissory note issued by corporations to raise funds for immediate financial needs. These notes typically mature within 270 days and are traded in the money market. Since it is not backed by collateral, only firms with high credit ratings can comfortably issue commercial paper.

Phonetic

The phonetic pronunciation of “Commercial Paper” is /kəˈmɜːrʃəl ˈpeɪpər/.

Key Takeaways

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  1. Short-Term Unsecured Promissory Notes: Commercial paper refers to a type of unsecured, short-term debt instrument that is issued by corporations, typically for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities.
  2. Maturity Period: Maturities on commercial paper can range anyplace from 1 to 270 days. Due to its short-term nature, commercial paper is often a less expensive option for the borrower compared to long-term debt.
  3. Risk and Reward: Because commercial paper isn’t backed by collaterals, only firms with high-quality debt ratings will easily find investors without having to provide a substantial discount for the debt issue. Therefore, the risk associated with commercial paper is relatively high, but so are the returns for the investor.

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Importance

Commercial paper is a crucial instrument in the business and finance realm because it provides a short-term borrowing option for large corporations to fund immediate needs like payroll, accounts payable, and inventory. It’s essentially an unsecured debt that typically matures in 270 days or less. The importance of commercial paper lies in its effect on corporate liquidity management, and its interest rates make it a cheaper alternative to bank loans. Furthermore, it provides a valuable investment option for money market funds due to its high liquidity and low-risk characteristics. This emphasizes the fundamental role of commercial paper in maintaining smooth business operations and contributing to financial market dynamics.

Explanation

Commercial Paper is a short-term debt instrument issued by large corporations to obtain funds to meet immediate financial needs. This tool serves as an effective way for companies to sustain their cash flow with minimal administrative procedures or regulatory compliance. The primary purpose of commercial paper is to cover short-term operational expenses such as inventory purchases, payrolls, and other immediate liabilities.Using commercial paper, companies can essentially write IOUs that are then bought by investors or other firms, with the promise of returning the investment plus interest after a specific period, typically not exceeding 270 days. Due to its high liquidity and short maturity period, commercial paper is considered a safe investment, often preferred by money market funds, mutual funds, and individual investors seeking temporary places to park cash. This method is vital for maintaining continuous operations and smoothing gaps in revenue, thus allowing corporations to manage their liquidity more efficiently.

Examples

1. Apple Inc.: In 2017, the tech giant Apple Inc. utilized commercial paper to finance its day-to-day operations. Instead of relying exclusively on long-term debt, Apple issued short-term unsecured obligations known as commercial papers to meet its immediate needs, such as payroll, inventories, and other short-term liabilities.2. Berkshire Hathaway: Berkshire Hathaway, owned by Warren Buffet, is also known for using commercial paper as an instrument for short-term borrowing. The company generally uses the funds raised through this method for its operational needs, including expenses related to its various subsidized companies.3. General Motors: For decades, the automobile giant General Motors has used commercial paper to finance its operating activities. These included production, assembly, marketing materials, and expanding its dealership network around the world. However, during the 2008 financial crisis, General Motors was unable to repay some of its commercial paper obligations when they matured, contributing to its bankruptcy.

Frequently Asked Questions(FAQ)

What is Commercial Paper?

Commercial Paper can be defined as a short-term, unsecured money market instrument issued by highly rated large corporations. This tool is primarily used to meet short-term liabilities or day-to-day operations.

How long is the typical maturity period of commercial paper?

The typical maturity period of commercial paper usually ranges from a few days up to 270 days. However, the most common duration is 30 to 50 days.

Is commercial paper considered safe?

Commercial paper is generally considered to be a safe investment due to its short-term nature and the creditworthiness of the companies that issue it. However, it is not entirely risk-free, as issuers can default.

What is the advantage of commercial paper for corporations?

Commercial paper is a cost-effective way for corporations to raise funds. They usually offer lower interest rates compared to bank loans, hence provide corporations a cheaper source of short-term debt.

Can individual investors invest in commercial paper?

Yes, individual investors can invest in commercial paper. However, it is more commonly bought by money market funds, other businesses, or institutional investors due to high minimum investments usually required.

Who regulates the commercial paper market?

In the United States, the commercial paper market is not regulated by the Securities and Exchange Commission (SEC), but it is subject to the SEC’s anti-fraud rules. The Federal Reserve also oversees this market.

How is commercial paper sold?

Commercial paper can be either sold directly by the issuing entity to investors or via broker-dealers. Most commercial paper is sold at a discount from face value, meaning investors purchase it for less than its face value and are then paid the full face value at maturity.

How does the fluctuation in interest rates affect commercial paper?

Interest rates have an inverse relationship with the price of commercial paper. If interest rates rise, the value of existing commercial paper decreases, and vice versa.

What happens if a company fails to pay at maturity?

If a company fails to pay the commercial paper at maturity, it is seen as a default, which can harm the company’s credit rating significantly. When a default occurs, the investor may lose a part or all of their principal investment.

Related Finance Terms

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