What are Commercial Papers? Advantages of Commercial Paper

Let’s take a look into one of the most popular forms of debt instruments introduced by the Indian government post the liberalization of the economy.

What are Commercial Papers?

A commercial paper is an instrument of the money market containing a short term maturity. Commercial papers come with the flexibility of different maturities that ranges to about 270 days. Commercial papers are mainly issued by entities with a high credit rating like big firms and corporations to meet their short-term liabilities. Issuers can raise a considerable sum of money from investors through commercial papers. These instruments are issued at a discount from the face value which depends on the prevailing interest rate and the reputation of the issuing entity.

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Commercial Paper in India:

Commercial papers set its foot in India in the year 1989. The RBI introduces commercial papers on 27th march on the same year in the Indian money market. It was recommended for registration based on the below-given points:

• The authority to issue commercial papers was only given to companies that have a net worth of 5 crores and above which have an excellent track record of dividend payment
• The market should follow the CAS discipline. The RBI would exercise control and supervise the paper amount, entry of the market and the total quantum that can be upgraded in a year.
• The government has imposed no limitations on the money market. However, the size of the note issued has certain limitations on it. The size of one issue and each lot is capped at Rs. 1 crore and above and Rs. 5 lakhs and above respectively.
• The paper can be issued in a form that promises an interest payment that is given at a discounted rate and redeemed at face value.
• The company issuing commercial papers must have a debt ratio not more than 105, a debt servicing ratio closer to 2 with a current ratio not less than 1033 and should be listed on the stock exchange.

See Also: Features Of Indian Money Market

Features of Commercial Paper:

Some important features of commercial papers are given below:

• Commercial papers are traded at the money market and are issued for a short tenure with a set maturity date.
• Commercial papers can be used as evidence of an unsecured debt
• Commercial papers are issued at a discounted rate and are redeemed at its face value. Thus it acts as an interest-bearing instrument
• The issuer promises the buyer to pay a pre-specified amount at the time of maturity. The amount is paid in cash and not in the form of dividends or assets.
• The issuer of commercial papers can issue the papers either through banks or dealer banks or directly to the investors. 

Advantages of Commercial Paper:

• When compared to other sources like bank loans and loans from other financial institutions, commercial papers can provide more funding at a lower interest rate.
• It a debt instrument trade at the money market, commercial papers are highly liquid and comes with a range of maturities offering investors with high flexibility.
• It does not contain any restrictions on it. Also, they are highly secure as they are issued by companies with high credit ratings.
• Companies can save some funds by issuing commercial papers that they had to otherwise pay as interest for bank loans. Investors can earn good returns on them while maintaining the liquidity of the invested amount.
• These are instruments that produce a continuing source of funds. The reason is the maturity of these funds can be customized to suit the requirements of the issuing entity. Additionally, the matured commercial papers can be repaid by issuing fresh commercial papers at the money market. Thus the company will have to go through minimum losses.

See Also: Functions Of Money Market

Types of Commercial Paper:

Commercial papers can be classified into four separate categories, which are as follows:

Draft: it is a third party paper confirming the payment to the bearer. It is popularly used to safeguard payments that take place in overseas transactions. The draft is issued by an entity to the other promising to pay an amount through a third party.

Cheque: a cheque is a type of commercial paper where the drawee is a bank. A cheque is payable on demand to the specified bearer.

Promissory Note: one of the most popular forms of commercial papers which is a promise to pay money. As per the promissory note, the issuer promises to pay an amount to the entity that is in possession of the note.

Certificate of Deposit: the certificate of deposit is a confirmation by the bank of the acquisition of a specific sum of money from the depositor for a fixed time period. The bank repays the amount to the depositor after the fixed period along with interest payment.

See Also: All You Need To Know About Money Market

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