Commercial Paper, Certificate Of Deposit
Commercial paper is an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts payable and inventories, and meeting short-term liabilities. Maturities on commercial paper rarely range longer than 270 days. Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.
Commercial paper is not usually backed by any form of collateral, making it a form of unsecured debt. As a result, only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue. Because commercial paper is issued by large institutions, the denominations of the commercial paper offerings are substantial, usually $100,000 or more. Other corporations, financial institutions, wealthy individuals and money market funds are usually buyers of commercial paper.
Advantages of commercial papers
(i) It is quick and cost effective way of raising working capital.
(ii) Best way to the company to take the advantage of short term interest fluctuations in the market
(iii) It provides the exit option to the investors to quit the investment.
(iv) They are cheaper than a bank loan.
(v) As commercial papers are required to be rated, good rating reduces the cost of capital for the company.
(vi) It is unsecured and thus does not create any liens on assets of the company.
(vii) It has a wide range of maturity.
(viii) It is exempt from federal SEC and State securities registration requirements.
Disadvantages of commercial papers
(i) It is available only to a few selected blue chip and profitable companies.
(ii) By issuing commercial paper, the credit available from the banks may get reduced.
(iii) Issue of commercial paper is very closely regulated by the RBI guidelines.
Example of Commercial Paper
An example of commercial paper is when a retail firm is looking for short-term funding to finance some new inventory for an upcoming holiday season. The firm needs $10 million and it offers investors $10.1 million in face value of commercial paper in exchange for $10 million in cash, according to prevailing interest rates. In effect, there would be a $0.1 million interest payment upon maturity of the commercial paper in exchange for the $10 million in cash, equating to an interest rate of 1%. This interest rate can be adjusted for time, contingent on the number of days the commercial paper is outstanding.
CERTIFICATE OF DEPOSIT (CD)
A certificate of deposit is an agreement to deposit money for a fixed period with a bank that will pay you interest. You can choose to invest for three months, six months, one year or five years. You will receive a higher interest rate for the longer time commitment. You promise to leave all the money, plus the interest, with the bank for the entire term.
In effect, you are lending the bank your money in return for interest. The CD is a promissory note that the bank issues you. That’s how banks acquire the cash they need to make loans. The interest you receive is less than the pay earns for lending it out. That’s how banks earn a profit. But you earn a higher interest rate than you would for an interest-bearing checking account. That because you can’t withdraw the funds for the agreed-upon time.
Advantages of Certificate Of Deposit
- Flexible Terms: The terms and the amounts that can be deposited into a CD are flexible. If you are not willing to tie up your money for a long time, you can easily opt for a shorter term. At the end of a CD term, you can renew that CD or start a new one.
- Safety: CDs that are available from a federally insured institution are generally insured up to $250,000. This takes much of the risk out of the investment.
- Better Return than Saving Accounts: Since the CD holder is not allowed to withdraw money freely like savings account holders, a CD is often more valuable to the financial institution. For this reason, the interest rate offered to a CD holder is higher than a traditional savings account.
- Wide Selection: You can get a CD at various maturities and terms from different financial institutions. Because of the diversity of CDs, investors can find a CD that meets their individual needs.
- Fixed, Predictable Return: The investor can be sure about getting a specific yield at a specific time. Even if the interest rates come down to a broader economy, the CD rate will remain constant. You will be able to easily determine the rate at which your balance will grow, thus making financial planning easy.
Disadvantages of Certificate Of Deposit
- Limited Liquidity: The owner of a CD cannot access their money as easily as a traditional savings account. To withdrawal money from a CD before the end of the term requires that a penalty has to be paid. This penalty can be in the form of lost interest or a principal penalty. To increase flexibility, the investor can create a CD Ladder, which is composed of CDs with different maturity dates and terms. With a laddering strategy, you have more options to access your CD savings at different intervals of time.
- Inflation Risk: CD rates may be lower than the rate of inflation. This means that your money may lose its purchasing power over time if interest gains are outdone by inflation rates.