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Commercial paper

What Is Commercial Paper?

Commercial paper is a commonly used type of short-term debt instrument issued by large corporations and financial institutions to cover short-term liabilities. As a component of the broader money market, commercial paper represents an unsecured debt obligation that typically has a fixed maturity date ranging from a few days to 270 days. Companies issue commercial paper as a cost-effective way to meet immediate cash needs, such as funding working capital or inventory.

History and Origin

The origins of commercial paper can be traced back to the 19th century in the United States, serving as a vital source of short-term financing for businesses. Initially, it was predominantly a direct placement market where large firms would issue these notes directly to investors. Over time, the market evolved, with dealers playing an increasingly important role in facilitating transactions between issuers and investors. The growth of the commercial paper market reflected the expanding needs of corporations for flexible, short-term funding beyond traditional bank loans. Its structure as a short-term, unsecured obligation made it attractive for well-established companies seeking to bypass banks and access capital directly from the market. Charles L. Evans of the Federal Reserve Bank of Chicago provided insights into the commercial paper market's structure and dynamics in the late 1980s, highlighting its role in the U.S. financial system.

Key Takeaways

  • Commercial paper is an unsecured, short-term debt instrument issued by corporations and financial entities.
  • It is used to finance short-term liabilities and working capital needs.
  • Maturities typically range from overnight to 270 days, avoiding Securities and Exchange Commission registration requirements for longer terms.
  • Issued at a discount to its face value, the investor earns the difference upon maturity.
  • Issuers are typically large, financially stable companies with high credit ratings.

Formula and Calculation

Commercial paper is typically issued at a discount rate to its face value, meaning investors pay less than the stated maturity value and receive the full face value when the paper matures. The yield an investor earns is the difference between the purchase price and the face value, annualized.

The formula to calculate the purchase price of commercial paper, given its face value, discount rate, and days to maturity, is:

Purchase Price=Face Value×(1−(Discount Rate×Days to Maturity360))\text{Purchase Price} = \text{Face Value} \times \left(1 - \left( \text{Discount Rate} \times \frac{\text{Days to Maturity}}{360} \right)\right)

Where:

  • Face Value = the amount the investor will receive at maturity.
  • Discount Rate = the annualized yield (expressed as a decimal).
  • Days to Maturity = the number of days until the commercial paper matures.
  • 360 = the number of days in a commercial year (standard for money market instruments).

Alternatively, to calculate the annualized yield (discount rate) if you know the purchase price:

Discount Rate=Face Value−Purchase PriceFace Value×360Days to Maturity\text{Discount Rate} = \frac{\text{Face Value} - \text{Purchase Price}}{\text{Face Value}} \times \frac{360}{\text{Days to Maturity}}

Interpreting Commercial Paper

Commercial paper is largely interpreted based on its yield and the issuer's credit quality. A lower yield on a company's commercial paper indicates higher market confidence in its ability to repay, reflecting a strong liquidity position and robust financial health. Conversely, a higher yield suggests increased perceived risk by investors, demanding greater compensation for holding the unsecured debt. Investors continually assess the issuer's financial institutions and creditworthiness to gauge the safety of their investment. Changes in the prevailing interest rate environment also impact commercial paper yields, as they compete with other short-term investments.

Hypothetical Example

Suppose Apex Corp. needs to raise cash for a new project and decides to issue commercial paper. They issue commercial paper with a face value of $1,000,000, a maturity of 90 days, and an annualized discount rate of 3%.

To calculate the purchase price for an investor:

Purchase Price=$1,000,000×(1−(0.03×90360))\text{Purchase Price} = \$1,000,000 \times \left(1 - \left( 0.03 \times \frac{90}{360} \right)\right) Purchase Price=$1,000,000×(1−(0.03×0.25))\text{Purchase Price} = \$1,000,000 \times \left(1 - \left( 0.03 \times 0.25 \right)\right) Purchase Price=$1,000,000×(1−0.0075)\text{Purchase Price} = \$1,000,000 \times \left(1 - 0.0075 \right) Purchase Price=$1,000,000×0.9925\text{Purchase Price} = \$1,000,000 \times 0.9925 Purchase Price=$992,500\text{Purchase Price} = \$992,500

An investor would pay $992,500 for this commercial paper today and receive $1,000,000 back in 90 days, earning a profit of $7,500. This example illustrates how the discount mechanism provides the return to the investor.

Practical Applications

Commercial paper is a cornerstone of short-term corporate finance and money market operations. Corporations use it extensively to manage seasonal cash flow needs, finance inventory purchases, or bridge gaps between receivables and payables. For investors, commercial paper offers a highly liquid, low-risk investment option for short-term capital, particularly for institutional investors such as money market funds, corporations, and pension funds seeking to park cash for brief periods. The scale of the commercial paper market underscores its importance in the global financial system, with the Federal Reserve providing regular updates on outstanding commercial paper to track market activity. As of May 2025, the total commercial paper outstanding in the U.S. remains a significant indicator of corporate short-term funding activity. Reuters has published explainers on why commercial paper matters, particularly during periods of market stress, underscoring its role in corporate finance. Issuance occurs in the primary market, and it can be traded in the secondary market, though it is less common due to short maturities.

Limitations and Criticisms

Despite its advantages, commercial paper carries certain limitations and risks. Being an unsecured debt instrument, its value and liquidity are highly dependent on the issuer's financial stability and creditworthiness. Should an issuer face financial distress or a credit rating downgrade, investors may face difficulties selling their commercial paper, or in severe cases, the risk of default. This vulnerability was starkly demonstrated during the 2008 financial crisis when the commercial paper market experienced a significant freeze, as investors grew wary of the solvency of even highly-rated issuers. The New York Times reported on the freeze in the commercial paper market during the 2008 crisis, highlighting its impact on corporate liquidity. This event underscored the systemic risk associated with a market reliant on investor confidence and the need for robust oversight. While generally considered low-risk for high-quality issuers, commercial paper is not without its perils, particularly during periods of economic uncertainty.

Commercial Paper vs. Promissory Note

While both commercial paper and a promissory note represent a written promise to pay a specified sum of money by a certain date, they differ significantly in their typical usage and market. Commercial paper is specifically a short-term, unsecured debt instrument issued by large corporations and financial institutions, primarily to raise working capital. It is typically issued at a discount and is traded in the money markets. A promissory note, on the other hand, is a more general term for a written promise to pay. It can be issued by individuals or companies of any size, for any duration (short-term or long-term), and can be secured or unsecured. Promissory notes are often used in personal loans, real estate transactions, or less formal business financing arrangements, and they may or may not be publicly traded. The key distinction lies in commercial paper's standardized, institutional nature within the money market for specific corporate financing needs, compared to the broader, more versatile application of a promissory note.

FAQs

What is the typical maturity of commercial paper?

Commercial paper typically has a short maturity, ranging from overnight to 270 days. Instruments with maturities beyond 270 days generally require registration with the Securities and Exchange Commission.

Who issues commercial paper?

Large, financially sound corporations and financial institutions with high credit ratings are the primary issuers of commercial paper. Their strong creditworthiness helps assure investors of repayment.

Why do companies issue commercial paper?

Companies issue commercial paper primarily to obtain short-term financing for operational needs, such as funding working capital, inventory, or payroll. It's often a more cost-effective alternative to traditional bank loans for short-term liquidity.

Is commercial paper a secure investment?

Commercial paper is generally considered a low-risk investment, especially when issued by highly-rated companies. However, it is an unsecured debt, meaning it is not backed by collateral. Its security depends heavily on the issuer's financial health and credit rating.