Commercial Paper

Commercial paper is a commonly used type of unsecured, short-term debt

instrument issued by corporations, typically used for the financing of
payroll, accounts payable and inventories, and meeting other short-term
liabilities. Maturities on commercial paper typically last several days, and
rarely range longer than 270 days. Commercial paper is usually issued at a
discount from face value and reflects prevailing market interest rates.
Commercial paper was first introduced over 150 years ago when New York
merchants began to sell their short-term obligations to dealers that acted
as middlemen in order to free up capital to cover near term obligations. These
dealers would thus purchase the notes at a discount from their par value and
then pass them on to banks or other investors. The borrower would
subsequently repay the investor an amount equal to the par value of the note.

Commercial paper is not usually backed by any form of collateral, making it a

form of unsecured debt. As a result, only firms with high-quality debt ratings
will easily find buyers without having to offer a substantial discount (higher
cost) for the debt issue. Because commercial paper is issued by large
institutions, the denominations of the commercial paper offerings are
substantial, usually $100,000 or more. Other corporations, financial
institutions, wealthy individuals, and money market funds are usually buyers of
commercial paper.

Advantages of Commercial Paper

A major benefit of commercial paper is that it does not need to be registered
with the Securities and Exchange Commission (SEC) as long as it matures
before nine months, or 270 days, making it a very cost-effective means of
financing. Although maturities can go as long as 270 days before coming
under the purview of the SEC, maturities for commercial paper average about
30 days, rarely reaching that threshold. The proceeds from this type of
financing can only be used on current assets, or inventories, and are not
allowed to be used on fixed assets, such as a new plant, without SEC
involvement.

Commercial Paper During the Financial Crisis

The commercial paper market played a big role in the financial crisis that
began in 2007. As investors began to doubt the financial health and liquidity of
firms such as Lehman Brothers, the commercial paper market froze, and firms
were no longer able to access easy and affordable funding. Another effect of
the commercial paper market freezing was some money market funds -
substantial investors in commercial paper - "breaking the buck." This meant
that the affected unds had net asset values under $1, reflecting the
diminishing value of their outstanding commercial paper issued by firms of
suspect financial health.

The Commercial Paper Funding Facility (CPFF) was subsequently created by

the Federal Reserve Bank of New York on October 27, 2008, as a result of the
credit crunch faced by financial intermediaries in the commercial paper
market. The Federal Reserve Bank of New York closed the CPFF in February
2010 after it no longer became necessary as the financial sector and broader
economy recovered.

Example of Commercial Paper

An example of commercial paper is when a retail firm is looking for short-term
funding to finance some new inventory for an upcoming holiday season. The
firm needs $10 million and it offers investors $10.1 million in face value of
commercial paper in exchange for $10 million in cash, according to prevailing
interest rates. In effect, there would be a $0.1 million interest payment upon
maturity of the commercial paper in exchange for the $10 million in cash,
equating to an interest rate of 1%. This interest rate can be adjusted for time,
contingent on the number of days the commercial paper is outstanding.