One way of raising short term financing is the use of Commercial Paper.
Commercial Paper is one of the many money market instruments for raising funds.
Before we proceed to understand Commercial Paper, let’s first understand what the term money market means.
Money market is:
- A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded.
- The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year.
- Money market securities consist of negotiable certificates of deposits (CDs), bankers acceptances, government Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).
Tabulate below describes what are Commercial Paper, its features/characteristics and its advantages and disadvantages:
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Commercial Paper & Its Features/Characteristics:
- Commercial Paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities.
- Maturities on commercial paper can range up to 365 days. The debt is usually issued at a discount, reflecting prevailing market interest rates.
- Commercial paper is not usually backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.
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Pros and Cons Of Commercial Paper
Advantages:
- For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months.
- Typically only companies with high credit ratings and credit worthiness issue commercial paper hence the companies issuing them enjoy (a) the prestige associated with such issuance and (b) the ability to issue large quantum without much hassles like other types of financing which requires restrictions from regulatory bodies.
- The interest rate is generally lower compared to others like bank loans and other types of short term financing
Disadvantages:
- It does not have any flexibility with regards to repayments.
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