Commercial paper is an unsecured, short period debt instrument issued by a company, usually for the finance and inventories, temporary liabilities, accounts payable, and meeting other short-term liabilities. Maturities on commercial paper are from seven days to 270 days but not longer than 270 days. Majorly Commercial papers are issued at a discount from its face value at the current market interest rate. These papers are like a promissory note allotted at a huge cost and exchangeable between the All-India Financial Institutions and Primary Dealers. Mainly various individuals, corporate, financial institutions, non-resident Indians, foreign institutional investors, and investors from various banking sectors purchase and trade this instrument.
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Commercial Paper in India – Scenario:
In 1990 the first time commercial paper where introduce in India as short term instrument in which various financial and nonfinancial institution were able to invest in it and trade it. Various financial bodies such as non-banking financial companies, banking companies, various corporate bodies that were registered and not registered in India, individuals, Non-Resident Indians (NRI), Financial Institutional Investors (FII), and various other financial organizations can invest in this instrument. The limit of investment from FII and various other organizations is controlled by the Security Exchange Board of India i.e. SEBI whose main work is to look after the share market and various investments happing in the country. If any company wants to register for the commercial paper its net worth should be more them 5 crores. And for using the same their debt ratio should be a maximum of 105, a debt servicing ratio closer to 2, a current ratio minimum of 1033, and should be recorded on the stock exchange. There is no stamp duty associated with the transfer and issuing of these instruments.
Features of Commercial Paper:
- The first and foremost feature of commercial paper is that it can be negotiable.
- It can be sold to another company by directly issuing them
- It acts as an evidence certificate of unsecured debt which is not backed by any assets of the company.
- The issuer guarantees the buyer to pay a fixed amount in the future in terms of liquid cash and no assets.
Advantages of Commercial Paper:
- The most important benefit of commercial paper is that it provides a short term funding to the companies for their day to day activities and for the need of working capital requirement.
- The funds provided by commercial paper are comparatively more than other commercial banks.
- It is a more flexible and highly liquidity instrument because of it, it is freely and easily transferable instrument.
- These instruments are highly secure to trade.
- Various organizations use commercial paper to save their extra funds and gain a return on it.
- Any investors can easily recover their funds from this instrument as it provides the exit option to all investors.
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Limitations of Commercial Paper:
- If any company is in need of funds they cannot redeem it; the duration of commercial paper cannot be extended.
- Commercial paper is one type of old method of financing.
- Only financially secure and highly rated organizations can raise money through commercial papers. Any firm or organizations which are new in business cannot raise their fund through this method.
- Any investor can raise their fund through commercial paper up to the limit of liquidity available with them.
- By issuing commercial paper, the credit available from the banks may get reduced.
Types of Commercial Paper:
According to the Uniform Commercial Code (UCC), commercial papers are divided into 4 different types:
- Promissory note: It is a type of document which serves as a document of evidence of debt. On this, an investor can get the credit or loan according to its limit. This note is a kind of two-party paper where the maker is the person who promises to pay the payment to the payee or the holder.
- Draft: It is a three-party paper confirming the payment. Here drawer issues an order to pay and drawee is the party to whom the order to pay is given.
- Check: It is a form of the document in which the individual deposit a certain amount of money in the bank and in return bank promises a check to the holder for its amount.
- Certificate of deposit: Certificate of Deposit which is also known as CD this is basically a written document by the bank of the acquisition of the money from a depositor for a particular period of time and they promise to repay it with a specified interest rate.
According to security:
- Unsecured Commercial Papers: These are traditional papers and allotted to various institutions without any security.
- Secured Commercial Papers: It is also known as Asset-Backed Commercial Papers (ABCP) and assured by other financial assets.
According to nature:
- Financial commercial paper: These are issued by financial companies such as banks.
- Non-Financial Commercial Paper: These are issued by nonfinancial corporations, typically large industrial or service firms and utility companies.
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Various company and institution use this instrument mainly for meeting their short term fund requirement that can be of working capital and some of them also use this instrument for the proposal to invest and gain return as this instrument is for short term period so the money of any institution will not behold for a longer period. Thus, to come up with the solution for short-term fund requirements these instruments in the money market are highly used by various financial and non-financial institutions and companies.
Author: Charmi Mehta
About the Author: Charmi Mehta is currently pursuing an MBA with a specialization in Finance from the Department of Business Administration, Bhavnagar. Charmi is very much interested to work with data and its analysis and she is also fascinated by the financial market.