Finance

Asset-Backed Commercial Paper

Asset-Backed Commercial Paper

Asset-backed commercial paper is collateral backed by other financial assets. Institutional investors generally buy such instruments to diversify their assets and generate short term gains. It is issued by a special purpose vehicle (SPV) or a mechanism established by a sponsoring financial institution.

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What is Asset-Backed Commercial Paper (ABCP)

An Asset-backed commercial paper (ABCP) is a short-term investment vehicle whose maturity is less and is between 90 to 270 days. ABCP is financial collateral for the financial vehicle. The APCB is backed by companies asset-backed securities, residential mortgages, commercial loans, etc. companies will use ABCP for short-term financial needs. A company can create ABCP from any type of asset-backed security such as subprime mortgages which are high risk and we will know the effect of this security in further points where the 2008 financial crises are explained. The primary diff between commercial paper and asset-backed security is that commercial paper is not backed by an asset.

How is ABCP Created?

ABCP (Asset-Backed Commercial Paper) creation begins with the sellers of the securities underlying asset for eg. There is a bank that wants to finance its credit receivables then if it has given a car loan it will go to a service provider which will convert these receivables i.e asset of the bank into security and can be sold in the market. The conversion into security is done by a special purpose vehicle. after creating this security the investors invest in such security as they get returns in the form of interest paid by the people who took the car loans. Hence in this way, asset-backed commercial papers as created by special purpose vehicles and sold in the market for short-term investment.

This diagram represents how an ABCP works.

Asset-backed commercial paper

 

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How it is different from Commercial Paper?

The main distinction between commercial paper and asset-backed commercial paper is that the commercial paper is not backed by financial assets. The commercial paper serves only as a promissory note, secured by the high credit rating of the issuing firm. Asset-backed commercial paper is often issued by firms with a high credit rating but also additional asset-backed securities.

Role of ABCP in financial crises:

The financial crises in 2008 were caused due to ABCP’s mortgage-backed security, where banks used special purpose vehicles to convert their home loans into security and sell them to investors as ABCP. Due to MBS banks had more liquidity and started giving loans to everyone and lowered their lending standards. As loans were given to everyone most of them started defaulting and this led to the security becoming more illiquid. When some asset prices dropped it created a sense of panic and investors started selling their security and as it became illiquid the market faced a great downfall which was one of the main reasons for the 2007-09 financial crises. Hence ABCP is riskier even though it is backed by an asset.

Conclusion:

ABCP investors need to understand the composition of the underlying asset & value of those assets in which they are investing as it might get impacted by market volatility and create a downturn in the economy.

 

Author – Hariharan Krishnan

About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.

 

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