Debt Instruments – What is Commercial Paper?

What is Commercial Paper?

Commercial Paper (CP) is an ‘IOU’ issued by a company for short term funding. Paper is issued for periods up to 12 months but more often for 1- and 3-month periods. Banks act as intermediaries between issues and investors, and may also provide a back-up facility in case an insufficient number of investors can be found.

Commercial paper programmes normally require two ratings by reputable agencies, which invariably insist on adequate back-up facilities being in place. The issue of commercial paper is subject to different rules as to maturity, size, type of issuer etc. in different countries. In theory, CP can be traded between investors, but it is more usual for paper to be issued in a size and maturity to suit investor requirements.

A bank can issue commercial paper to raise the funds needed. It can then sell these short-term securities to institutional investors, such as money market funds, at a discount. The bank receives the funds it needs, while the investors receive a return in the form of interest payments on the commercial paper. The bank repays the face value of the commercial paper when it matures.

How does Commercial Paper reflect in financial statements?

In a financial statement, commercial paper would be included in the current liabilities section and would be reported at the discounted amount. The discount represents the interest that will be earned over the life of the security. The amount of commercial paper outstanding would be reported in the balance sheet, and any changes in the amount of commercial paper would be reflected in the cash flow statement.

Benefits of Commercial Paper

  1. Short-term funding: Commercial paper provides companies with a source of short-term funding to meet their liquidity needs.
  2. Low cost: It is typically issued at a discount to face value, making it a relatively low-cost form of borrowing compared to other forms of debt.
  3. Flexibility: Companies can issue commercial paper in amounts that meet their specific needs, making it a flexible funding option.
  4. High demand: Commercial paper is widely accepted by investors, making it easy to sell, even in large quantities.

Risks of Commercial Paper

  1. Credit risk: The issuer’s creditworthiness is a key factor in the value and liquidity of commercial paper. If the issuer experiences financial difficulties, it may default on the commercial paper, leading to a loss for the investor.
  2. Market risk: The value of commercial paper is dependent on market conditions, and it can become less valuable if interest rates rise or the overall market conditions deteriorate.
  3. Liquidity risk: Commercial paper is typically issued in large amounts, making it difficult to sell in the secondary market, especially in times of market turmoil.
  4. Interest rate risk: The discounted rate of commercial paper is subject to market forces and can fluctuate, leading to changes in the yield.

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