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Money markets are financial markets where parties transact in short-term debt instruments. Usually, money markets involve a large volume of transactions between sellers and buyers. These usually include institutions and traders. Similarly, several types of debt instruments are available on money markets. One of these includes commercial papers.
What is a Commercial Paper?
A commercial paper is a type of promissory note offered by financial institutions or large companies. These papers are unsecured and short-term, lasting or 270 days or less. Usually, borrowers issue commercial papers to raise short-term finance. Some companies use commercial papers to finance their production, accounts payable, payroll, or other short-term needs. Therefore, these can be a viable way for companies to fund their working capital requirements.
Usually, borrowers issue commercial papers at a discount from the face value. The reason for it is that these are short-term debt instruments. Since borrowers need these funds in a short time, they offer discounts to lenders to obtain finance quickly. Despite that, commercial papers provide borrowers with a more inexpensive method of funding compared to other sources.
How do Commercial Papers work?
Commercial papers are a form of promissory notes, which are written promises from one party to another. These notes include the amount that the borrower has to pay the lender. They may also consist of other terms, such as interest rates, maturity date, etc. Therefore, when borrowers issue a commercial paper, it is a document that contains a promise that the borrower will pay the lender.
Commercial papers are unsecured debt instruments. Borrowers usually prefer these instruments due to the ease of issuing and lower costs involved. Like other debt instruments, once commercial papers reach their maturity period, the borrower will be liable to repay the lender. The repayment usually includes both the principal amount and any interest payable involved.
Compared to other debt instruments, commercial papers involve more risks for the lender. However, they can also benefit from these transactions in two ways. Firstly, they get interest payments on these instruments, which is a primary income source. Secondly, the difference in the face value and discounted price paid also represents a profit for them.
What are the advantages and disadvantages of Commercial Papers?
Commercial papers have several advantages. Usually, they cost lower for both lenders and borrowers. Commercial papers are also unsecured instruments and do not create any lien on a borrower’s assets. Similarly, these instruments also come with a wide range of maturity, providing more flexibility to investors. As mentioned, commercial papers can also be profitable investments.
However, there are some problems that these instruments may have. For lenders, they involve more risks due to the lower credit rating and low liquidity. For companies, issuing such debt instruments can also lower bank credit limits. Usually, commercial papers are only available to large companies, meaning smaller companies can’t benefit from these.
Commercial Paper Example
A company, Bright Co., undertakes a new project that requires it to increase its production. However, the company does not have enough capital to do so. After weighing in various options, the company’s management concludes that it should issue commercial papers. Bright Co. offers commercial papers for a face value of $10 at a 10% discount. The company offers 5% interest on these.
Bright Co. successfully obtains funding through commercial papers. The company uses these funds to finance the new project. At maturity, the company repays its lenders. This repayment will amount to $10.5 per commercial paper. For lenders, the total profit on the commercial paper will be $1.5. This amount will include the $1 due to the discount received and $0.5 of interest on the paper.
Conclusion
Commercial papers are a type of money market instrument that are short-term and unsecured. These instruments usually have a maturity period of 270 days or less. Mostly, borrowers use commercial papers to fund their short-term operations. These borrowers will also offer a discount on their instruments. Commercial papers can be advantageous and disadvantageous for both borrowers and lenders.
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