Commercial Paper

Commercial Paper is a short-term, unsecured debt instrument issued by corporations to meet immediate financial needs, typically maturing in a range from a few days to up to 270 days.

Understanding Commercial Paper

Commercial paper serves as a means for companies to finance their short-term liabilities, including payroll, inventory purchases, and other operational costs. Since it is unsecured, it is primarily issued by companies with strong credit ratings, meaning lenders have confidence in their ability to repay.

Key Features of Commercial Paper

• Short-term maturity: Generally issued for periods ranging from a few days to 270 days.
• Unsecured: Does not require collateral, based on the issuer’s creditworthiness.
• Discounted instrument: Issued at a discount to its face value and redeemed at maturity for the full face value.
• High denomination: Typically issued in large amounts, often in increments of $100,000 or more.
• Market traded: Can be bought and sold in the secondary market.

Example of Commercial Paper

Consider a company, XYZ Corp., which needs $1 million to cover its operating expenses for the next 30 days. Instead of taking out a bank loan, XYZ Corp. decides to issue commercial paper.

Issuance Details

• Face value: $1,000,000
• Maturity: 30 days
• Discount rate: 2%

XYZ Corp. offers its commercial paper at a discount rate of 2%. Thus, the issuing price (the amount investors will pay) can be calculated as:

Calculation of the Issuing Price

To calculate the price at which the commercial paper is issued:

Issuing Price = Face Value / (1 + Discount Rate * (Days to Maturity / 360))
Issuing Price = $1,000,000 / (1 + 0.02 * (30 / 360))
Issuing Price = $1,000,000 / (1 + 0.005555)
Issuing Price = $1,000,000 / 1.005555
Issuing Price ≈ $994,480.94

Hence, investors would pay approximately $994,480.94 for the commercial paper, and upon maturity, they would receive the full face value of $1,000,000.

This mechanism allows XYZ Corp. to efficiently address its short-term funding gap while providing investors with a low-risk investment option, backed by a reputable corporation’s promise to repay.