What is Commercial Paper? Definition, Types

Meaning of Commercial Paper

Commercial paper is an unsecured, short period debt tool issued by a company, usually for the finance and inventories and temporary liabilities. The maturities in this paper do not last longer than 270 days. These papers are like a promissory note allotted at a huge cost and exchangeable between the All-India Financial Institutions (FIs) and Primary Dealers (PDs).

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.

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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 Vaghul working Group on the basis of 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 record.
• The market should follow the CAS discipline. The RBI should manage the paper amount, entry of the market, and total quantum which can be upgraded in a year.
• 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 minimum 5 cores as net worth, a debt ratio maximum of 105, a debt servicing ratio closer to 2, current ratio minimum 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.

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Features of Commercial Paper

Few distinct features are:

• It is a short-term money market tool, including a promissory note and a set maturity.
• It 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 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.

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Types of Commercial Paper

According to the Uniform Commercial Code (UCC), commercial papers are divided into four different types.

• Draft – It is written guidance by an 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 deposit.

According to security, there are two types of commercial papers

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

Students might also want to check: What is Stock Exchange?

Advantages of Commercial Paper

• 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 condition.
• Save Money – On commercial paper, companies can save extra cash and earn a good return.
• Lasting Source of Funds– Maturity range can be customised according to the firm’s requirement, and matured papers can be paid by selling the new commercial paper.

Commercial Paper Formula

The formula for estimation 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 Example

Calculate the interest yield of the following commercial paper:

Solution:

Brokerage = 3% of ₹500,000 = ₹15,000

Net Sale Price = ₹490,000 – ₹15,000 = ₹475,000

Yield = [(Face Value – Sale Price)/Sale Price] * (360/Maturity Period) * 100

= (5,00,000 – 4,75,000)/4,75,000 * (360/100) * 100

= 18.95%

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