Commercial paper (CP) is an unsecured, short-term debt instrument issued by corporations or financial institutions with high credit ratings. It is typically used to raise short-term funds to meet the operational needs of businesses, such as paying salaries, purchasing inventory, or repaying short-term debts. In the United States, the minimum denomination of commercial paper is $100,000, and the maturity ranges from 1 day to 270 days, with an average of 30 days.
Types of Commercial paper
Promissory note: Promissory note is a written promise to pay a specific amount of money unconditionally on a specific date. In the modern financial system, promissory note is an important credit instrument, which can be endorsed and transferred so as to circulate in the market, and is therefore regulated by relevant laws in all countries.
Draft: A draft (or bill of exchange) is a negotiable instrument whereby the drawer unconditionally orders the drawee to pay a specified sum of money to the payee or to the bearer on demand or at a fixed or determinable future time. It is essentially a written order for payment involving three parties: the drawer (issuer), the drawee (payer), and the payee (beneficiary).
Banker's Acceptance: A banker's acceptance is a time draft that has been accepted and guaranteed by a bank, essentially transforming it into a bank's obligation to pay. They are commonly used in international trade to facilitate secure payment to exporters. The bank's acceptance adds a layer of creditworthiness and marketability to the instrument, allowing it to be traded in the secondary market before maturity.
Certificate of Deposits (CDs):CDs are time deposits issued by banks that pay a fixed interest rate for a specified period. CDs are considered low-risk investments since they are backed by the issuing bank; however, there may be a dollar cap as to the amount that is insured. While they are technically not unsecured like most commercial paper, large denominations of CDs are often included in the broader category of commercial paper because of their relative level of liquidity and short-term nature (assuming a more brief CD length).
Characteristics of Commercial Paper
Short-term: Commercial paper usually matures within one year, and some even have a maturity of only a few days.
Unsecured: Commercial paper is not backed by any specific assets, and its credit risk mainly depends on the creditworthiness of the issuing company.
Liquidity: Commercial paper can be traded in the secondary market and has a certain degree of liquidity.
Low cost: Compared with other financing methods, the issuance cost of commercial paper is relatively low.
Advantages and Disadvantages of Commercial Paper
Advantages
Low financing cost: The interest rate of commercial paper is usually lower than other financing methods such as bank loans, which can help companies reduce financing costs.
Simple procedures: The issuance process of commercial paper is relatively simple, no collateral is required, and the approval process is fast.
Increased financial flexibility: The issuance of commercial paper can increase the financing channels of enterprises and improve financial flexibility.
Disadvantages
Credit risk: Commercial paper is an unsecured debt instrument. If the issuing company's financial situation deteriorates or it is unable to repay on time, investors will face losses.
High issuance threshold: Usually, only companies with high credit ratings can issue commercial paper, and it may be difficult for small and medium-sized enterprises (SMEs) to obtain this type of financing.
Liquidity risk: In the event of market fluctuations, commercial paper may be difficult to sell or can only be sold at a lower price.
Refinancing risk: The maturity of commercial paper is relatively short, and companies need to refinance continuously, which increases the complexity of financial management.
Commercial paper is a flexible and low-cost short-term financing tool, but it also carries certain risks, such as credit risk, high issuance thresholds, liquidity risk, and refinancing risk. Enterprises need to comprehensively consider their own financial situation, market environment, and risk tolerance when deciding whether to issue commercial paper. Similarly, investors need to assess the creditworthiness and financial status of the enterprise to reduce investment risks.
