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What is Commercial Paper?

The commercial paper refers to a short-term, unsecured debt obligation that is issued by financial institutions and large corporations as an alternative to costlier methods of funding. It is a money market instrument that generally comes with a maturity of up to 270 days.

Most of the commercial paper investors are from the banking sector, individuals, corporate and incorporated companies, Non-Resident Indians (NRIs) and Foreign Institutional Investors (FIIs), etc. However, FII can only invest according to the limit outlined by the Securities and Exchange Board of India (SEBI)

In India, commercial paper is a short-term unsecured promissory note issued by the Primary Dealers (PDs) and the All-India Financial Institutions (FIs) for a short period of 90 days to 364 days.

Commercial Paper in India

On 27th March 1989, commercial paper in India was introduced by RBI in the Indian money market. It was initially recommended by the Vaghul Working Group based on the following points.

  • The registration of commercial papers should only be granted to companies having Rs. 5 cores and above net worth with excellent dividend payment records.
  • No limitation on the commercial paper market apart from the least size of the note. However, the size of one issue and each lot should not be less than Rs. 1 crore and Rs. 5 lakhs respectively.
  • It should be eliminated from the provision of insecure advances in the state of banks.
  • The company using commercial paper should have a minimum of 5 cores as net worth, a debt ratio maximum of 105, a debt servicing ratio closer to 2, a current ratio minimum of 1033, and should be recorded on the stock exchange.
  • The paper can be made in terms of interest or at a discount rate to face value.
  • It should not be compelled to stamp duty while issuing and transferring.

Features of Commercial Paper

  • It is a short-term money market tool, including promissory note and a set maturity.
  • Acts as an evidence certificate of unsecured debt.
  • It is subscribed at a discount rate and can be issued in an interest-bearing application.
  • The issuer guarantees the buyer to pay a fixed amount in the future in terms of liquid cash and no assets.
  • A company can directly issue the paper to investors, or it can be done through banks/dealer banks.

Types of Commercial Paper

  • Draft: It is written guidance by one individual to another and to pay a stipulated sum to a third party.
  • Check: It is a unique draft where the drawee is a bank.
  • Note: Here, an individual is promised to pay another individual or bank a particular amount.
  • Certificates of Deposit: In this type, a bank confirms the receipt of the deposit.

According to security, there are two types of commercial papers

  • Unsecured Commercial Papers: These are traditional papers and are allotted without any security.
  • Secured Commercial Papers: It is also known as Asset-Backed Commercial Papers (ABCP) and is assured by other financial assets.

Advantages

  • Contributes Funds: It contributes extra funds as the cost of the paper to the issuing company is cheaper than the loans of the commercial bank.
  • Flexible: It has a high liquidity value and flexible maturity range giving it extra flexibility.
  • Reliable: It is highly reliable and does not have any limiting conditions.
  • Save Money: On commercial paper, companies can save extra cash and earn a good return.
  • Lasting Source of Funds: The maturity range can be customized according to the firm’s requirement, and matured papers can be paid by selling the new commercial paper.

Formula

The formula for estimation of the discounted price of a commercial paper.

Price = Face Value/ [1 + yield x (no. of days to maturity/365)]

Yield = (Face value – Price)/ (price x no of days to maturity) X 365 X 100

Commercial Paper