Tuesday, 9 April 2013

What is Commercial Paper - Advantages and Disadvantages

Definition of Commercial Paper

Commercial paper is a short term discounted and unsecured promissory note to finance the short term needs of large institutional buyers. Many banks, governments and companies use such sort of funding to fulfil their needs.

Maturity time and Investors

The most important thing about commercial paper is that it matures within a short span of time and will not usually exceed 270 days. The average maturity period of commercial paper lies between thirty to thirty five days. Commercial paper is a low risk investment and is usually issued by those companies who have high credit ratings.

Commercial paper can be issued as an interest bearing note or it can traded at less than its par value (discount). So, investors usually buy commercial paper at less than par value and get the interest (profit), when it reaches maturity. The difference between the purchase price at the time of investment and the par value is the interest investors are seeking for. There are many investors in commercial paper industry that include commercial bank, trust departments and mutual funds. Commercial paper is always a better option to choose rather than going for large bank loans and paying a good deal interest on them.

Advantages of commercial paper

Commercial paper bears low risk and are considered as a safe and secure investment with a predictable return on investment. They help to establish national credit and also allow to enhance borrowing power with local banks. As previously mentioned, it’s a much cheaper way to source finance than the local banks that offer funds at high interest rates. The companies which issue commercial paper get two benefits out of it. They are able to able to enhance their prestige as a great credit worthy company and are able to issue greater chunks of commercial paper without any noticeable restriction from the regulatory authorities. Commercial paper give higher yields and one doesn't have to tie their funds for long term as they are short term investments.

Disadvantages of commercial paper

There is no secondary market for commercial paper and once your funds are tied up, it is difficult to get them out. You have to wait till the maturity time to get the face or par value for the commercial paper and to redeem funds. If we compare commercial paper with Treasury bills in terms of taxation, then T-bills are only taxed at federal level while commercial paper is taxed three times on federal, state and local level. Commercial papers are usually much expensive for general public to buy and only large corporations and banks can afford to buy them.

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