What is Commercial Paper (CP)?
Commercial Paper (CP) is a short-term, unsecured promissory note issued by corporations and other large institutions looking to finance their short-term liabilities at a lower interest rate than they could obtain through bank loans. Typically, commercial paper matures in 60 days or less in the United States but can have longer maturity periods in the United Kingdom. Because it is issued by creditworthy institutions and is considered to have a low default risk, CP is viewed as a reasonable alternative to Treasury bills and certificates of deposit.
Examples of Commercial Paper
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Corporate Financing: A large corporation like General Electric may issue commercial paper to finance payroll, accounts payable, or seasonal inventory purchases without tapping into its credit line.
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Asset-Backed Commercial Paper (ABCP): In this case, the CP is backed by financial assets such as receivables or other securities through a Structured Investment Vehicle (SIV). For example, a bank might issue ABCP secured by auto loan receivables.
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Insurance Companies and Pension Funds: These institutions often invest in CP to manage their liquidity needs effectively while earning slightly higher returns as compared to other short-term investments.
Frequently Asked Questions (FAQs)
Q1: Who typically issues commercial paper? A1: Commercial paper is predominantly issued by large, creditworthy institutions like insurance companies, corporation trust departments, and pension funds.
Q2: How does commercial paper differ from Treasury bills? A2: Both are short-term financial instruments, but Treasury bills are issued by the government and considered risk-free, whereas commercial paper is issued by corporations and carries some credit risk depending on the issuer’s financial stability.
Q3: What is Asset-Backed Commercial Paper (ABCP)? A3: ABCP is a type of commercial paper that is secured by a pool of assets, such as receivables or other financial assets, providing a layer of security to the holders.
Q4: How did the subprime lending crisis affect the commercial paper market? A4: The subprime lending crisis in 2007 led to a significant decline in the market for Asset-Backed Commercial Paper (ABCP) due to the increased perceived risk and lack of liquidity in the financial markets.
Q5: Why do large companies prefer Commercial Paper over bank loans? A5: Companies prefer CP because it often comes with lower interest rates compared to short-term bank loans, making it a more cost-effective option for managing short-term financing needs.
Related Terms
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Treasury Bills (T-Bills): Short-term securities issued by the government with maturities ranging from a few days to 52 weeks.
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Certificates of Deposit (CDs): A financial product commonly offered by banks that provides a fixed interest rate for funds deposited for a specified term.
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Structured Investment Vehicle (SIV): A pool of investment assets designed to profit from credit spreads between short-term debt and long-term structured finance products.
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Subprime Lending: The practice of making loans to borrowers who have poor credit histories and are therefore considered higher credit risks.
Online References
- Investopedia - Commercial Paper Definition
- Federal Reserve - Commercial Paper
- SEC - Commercial Paper
Suggested Books for Further Studies
- “Financial Markets and Institutions” by Frederic S. Mishkin and Stanley G. Eakins
- “Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
Accounting Basics: “Commercial Paper Fundamentals Quiz”
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