Commercial Paper (CP), is a short-term debt instrument issued by companies to raise funds generally for a time period up to one year. They have a minimum maturity of 7 days and a maximum of up to one year. This article will give you insights of a topic of Economy – Commercial Paper, its types, advantages, disadvantages, etc.
This topic is important for prelims and Economy section of GS paper-III Economy UPSC mains examination.
Content
- About Commercial Paper
- Who can issue Commercial Paper?
- Types of Commercial Paper
- Advantages of Commercial Paper
- Disadvantages of Commercial Paper
About Commercial Papers (CPs):
- Commercial Papers (CPs), are short-term debt instruments issued by companies to raise funds generally for a time period up to one year.
- They have a minimum maturity of 7 days and a maximum of up to one year.
- It is an unsecured money market instrument issued in the form of a promissory note and was introduced in India for the first time in 1990.
- They are unsecured type of debt instrument as such instruments are not backed by collateral.
- It is issued at a discount and matures at its face value.
- They can be issued in denominations of Rs 5 lakh or multiples.
Who can issue Commercial Papers?
As per the RBI regulations, Commercial Papers can be issued by a number of institutions, especially companies. Following are the type of entities that can issue Commercial Paper as per the RBI regulations.
- Companies, including Non-Banking Finance Companies (NBFCs) and All India Financial Institutions (AIFIs).
- Any other body corporate with a minimum net worth of ₹100 crore or higher, provided that the body corporate is statutorily permitted to incur debt or issue debt instruments in India.
- Any other entity specifically permitted by the Reserve Bank.
- All residents and non-residents permitted to invest in Commercial Papers under Foreign Exchange Management Act (FEMA), 1999, are eligible to invest in Commercial Paper.
Types of Commercial Paper:
Four types of commercial paper: promissory notes, drafts, checks, and certificates of deposit (CDs).
Promissory notes:
- A promissory note is a legal financial instrument that contains a written promise by one party (the note’s issuer) to pay another party (the note’s payee) a definite sum of money.
- The issuer of commercial paper is the entity that is creating the short-term debt to fund their short-term cash needs.
- Repayment of the amount can be done either on demand or at a specified future date.
- A promissory note usually includes all the details of the debt, including the principal amount, interest rate, maturity date, date and location of issuance, and the signature of the issuer.
Draft:
- A draft is a written agreement between three parties: a bank (the drawer), a payer (the drawee), and a payee.
- The bank instructs the commercial paper issuer to pay the lender (payee) a specific amount of money at a specific time.
Checks:
- Checks are paid on demand by a bank rather than by a certain time.
- They are the fastest way to issue commercial paper.
- For this type of commercial paper, the issuing company instructs a bank to give the payee a specific amount of money instantly.
Certificates of Deposit:
- A certificate of deposit is exactly what the name implies: a bank receipt, or certificate, that asserts that the bank has received a sum of money deposited by an investor.
- It agrees to pay back this principle plus interest at a specific time in the future.
- The CD also states the interest rate to be paid and the maturity date.
Advantages of Commercial Paper:
- Commercial paper is easier to deal with as compared to the effort, time, and money involved in getting a business loan.
- It has a high liquidity value and wide range of maturity period.
- It is quite reliable and free of any restricting conditions.
- Issuers of Commercial Paper are in profit as they have to offer low interest rate.
- Investor has advantage of very low risk of default.
- Issuers create Commercial Paper to increase their liquidity as they may need cash in the short-term.
- Buyers may not need cash right away, so they are willing to buy and hold the instrument to increase their cash on hand in the future.
Disadvantages of Commercial Paper:
- Investors get a very low rate of interest on their investments.
- For issuing Commercial Paper, the company must have high credit ratings.
Conclusion
Commercial paper is a type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable, inventories, and meeting other short-term liabilities. Commercial papers are usually issued at a discount from face value and reflect prevailing market interest rates.
Commercial paper is an important tool for corporate finance managers. It helps in managing the working capital needs of the company efficiently and allows investors to park their surplus funds for short periods with relatively low risk compared to other unsecured forms of investment.
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Frequently Asked Questions
What are the 3 features of commercial paper?
It is a short-term money market instrument, similar to a promissory note, with a fixed maturity date. Commercial paper serves as a certificate of unsecured debt. It is issued at a discount rate and can be issued as an interest-bearing instrument.
Why commercial paper is called unsecured?
Commercial paper is unsecured because it is not usually backed by any form of collateral.