Commercial Paper Definition

Commercial Paper is defined as a money market instrument that is used for obtaining short-term funding and is usually in the form of a promissory notePromissory NoteA promissory note is defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date.read more issued by investment-grade banks and corporations. Most commercial papers are easily rolled over by paying for old issuance from the proceeds of new issuances. Hence it becomes a continuous source of funding.

  • Investments in such securities are made by institutional investors and high net worth individuals (HNI) directly & by others through mutual funds or exchange-traded funds (ETF).It is not meant for the general public, and hence, there is a restriction on the advertisement to market the securities. A secondary market also exists for commercial papers, but the market players are mostly financial institutions.It is issued at a discount to the face value, and upon maturity, the face value becomes the redemption value. It is issued in large denominations, e.g., $100,000.The maturity of commercial paper ranges from 1 to 270 days (9 months), but usually, it is issued for 30 days or less. Some countries also have a maximum duration of 364 days (1 year). The higher the duration, the higher, is the effective rate of interest on these papers.There is no need to register the papers with the Securities Exchange Commission (SEC), and hence, it helps in saving the administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more and results in lesser filings.

Types of Commercial Paper (Uniform Commercial Code – UCC)

As per the Uniform Commercial Code (UCC), commercial papers are of four kinds:

  • Draft – A draft is a written instruction by a person to another to pay the specified amount to a third party. There are 3 parties in a draft. The person who gives the instructions is called a “drawer.” The person who is instructed is called “drawee.” The person who has to receive the payment is called the “payee.”Check – This is a special form of the draft where the drawee is a bank. There are certain special rules which apply to a check. Hence this is considered to be a different instrument.Note – In this instrument, a promise is made by one person to pay another a certain sum of money to another. There are 2 parties in a note. The person who makes the promise and writes the instrument is called a “drawer” or “maker.” The person to whom the promise is made and to whom payment is to be made is called “drawee” or “payee.” It is also known as a “promissory note.” In most instances, a commercial paper is in the form of a promissory note.Certificates of Deposit (CD) – A CD is an instrument wherein the bank acknowledges the receipt of deposit. Further, it also carries details about maturity value, interest rate, and maturity date. It is issued by the bank to the depositor. It is a special form of the promissory note. There are certain special rules which apply to a CD. Hence this is considered to be a different instrument.

Types of Commercial Papers (On The Basis of Security)

On the basis of security, there are two types of commercial papers:

  • Unsecured Commercial Papers – These are also known as traditional commercial papers. Most of these papers are issued without any collateral, and hence, they are unsecured. The rating of the issue depends upon the asset quality and all other aspects relating to that organization. Rating is done in the same manner in which it is done for the bonds. These are not covered by the deposit insurance, e.g., Federal Deposit Insurance Corporation (FDIC) insurance in the U.S., and hence, investors obtain insurance from the market separately as a backup.Secured Commercial Papers – These are also known as Asset-backed commercial papers (ABCP). These are collateralized by other financial assets. These are normally issued by creating a Structured Investment vehicle that is set up by the sponsoring organization by transferring certain financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more. These papers are issued to keep off the instruments from the financial statementFinancial StatementFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more of the sponsor organization. Further, the rating agencies rate the issue on the basis of the assets kept in the Structured Investment Vehicle, ignoring the asset quality of the sponsor. During the financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, ABCP holders were one of the biggest loss-makers.

Calculate Yield of Commercial Paper

Formula for Yield Commercial Paper:

Yield = (Face Value – Sale Price/ Sale Price) * (360/Maturity Period) * 100

Example

Calculate the interest yield of the following commercial paper:

  • Face Value: $500,000Sale Price: $490,000Maturity period: 100Brokerage and Other charges: 3%

Solution:

  • Brokerage = 3% of $500,000 = $15,000Net Sale Price = $495,000 – $15,000 = $475,000

The calculation for Yield is as follows –

  • Yield = [(Face Value – Sale Price)/Sale Price] * (360/Maturity Period) * 100= (500,000 – 475,000)/475,000 * (360/100) * 100= 18.95%

Pricing of Commercial Paper

Formula for Pricing Commercial Paper:

Price = Face Value / [1+(Yield/100 * Maturity Period/360)]

Commercial Paper Example

Calculate the market price of the following example of commercial paper:

  • Face Value: $500,000Yield (after brokerage): 20%Maturity period: 100

The calculation for Pricing is as follows –

  • Price = Face Value / [1+{(Yield/100)*(Maturity Period/360)}]= 600,000 / [1+(20/360)]= $568,421

Advantages

  • No collateral is needed.Lower cost of funding.Lesser documentation and compliance.Highly liquid.It allows the diversification of funds in short-term instruments.High-rated instruments, hence fewer chances of default.For investors, returns are higher as compared to bank deposits.No restriction on the end-use of funds.

Disadvantages

  • Commercial paper can be issued by investment-gradeInvestment-gradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more banks and large corporations only. Hence it is not a source of funds which is available to all.Small investors cannot directly invest in commercial paper.The secondary market for commercial papers is less liquid.
  • The commercial paper market stood at $7.2 billion for the financial sector and $23 billion for the non-financial sector as of April 2019 month end as per Fed reserve.Most of the issuances are done in a 1-4 days bracket as per Fed reserve. A total of 112 issues were done in April 2019, and out of those, 47 issues were related to the 1-4 days bracket.Interest rates during April 2019 were ranging from 2.39% to 2.47% for institutions with AA rating and 2.46% to 2.56% for others as per Fed reserve.The commercial paper market is growing, and most of the investments are through prime money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more funds (MMF).

Conclusion

Commercial paper is a negotiable instrumentNegotiable InstrumentA negotiable instrument refers to the transferrable and signed written document whereby the payer guarantees or promises to pay a certain sum on a specific future date or as on-demand to the payee or bearer. It includes bills of exchange, delivery order, promissory note, customer receipt, etc.read more issued to get short-term credit. There are certain rules and restrictions on issuances, issuers, and investors. It is usually unsecured but, at times, backed by financial assets. The discount at which the instrument is issued results in the rate of return on commercial paper.

After the 2008 crisis, investors lost their confidence in this instrument, particularly asset-backed ones, but the same has now been restored. As a result, these papers are widely issued and invested in.

This has been a guide to Commercial Papers and its definition. Here we discuss the types of Commercial Papers along with its pricing examples, advantages & disadvantages. Here are the other articles in accounting that you may like –

  • Capital Lease AccountingFinancial Market OverviewIncome FundsFull-Form of NBFC