Money Markets – Commercial paper


Commercial papers a part of money markets, are financial instruments used to fund either current assets (such as inventories) or other operating expenses. They may not be used for fixed assets such as machinery and land, but they also do not have to be regulated by the SEC, provided they meet these and other qualifications, i.e. they must mature before nine months. Commercial papers are negotiable instruments and are governed by the Uniform Commercial Code. As of 2008, there are $1.78 trillion in total outstanding commercial paper. $801.3 billion are asset backed and $816.7 billion were issued by financial corporations.

Commercial paper is generally a safe investment that can be used for working capital or inventory purchases. As a low-cost alternative to bank loans, individuals can invest in these short-term unsecured promissory notes for numerous credit issuers, where the investments are somewhat secure.

There are five main advantages of investing in commercial paper. First, it allows the investor to borrow at cheaper rates compared to local banks. Second, the investor can establish national credit. Third, the investor can establish a broader market for the paper. Fourth, the investor can obtain cash and take advantage of trade creditors’ cash discounts. Finally, the investor can keep a reserve of borrowing money at local banks.


Money Markets – Issuing Paper

There are two methods – buy and hold and selling to dealer – to issue paper. First, the issuer can market securities to a buy and hold investor, which includes most money market funds. This strategy is good for the long term as most financial markets tend to give good rates of return. Here, unsophisticated buyers tend not to know when a security is worth purchasing; thus, it is safer to simply buy and hold. This strategy is an example of the efficient market hypothesis, which presumes that all securities are fairly valued and thus it does not behoove you to trade and sell unless you need the money.

However, there are arguments opposing the merits of this strategy. Day traders, for example, hold the concept that money can be made in the short term when an individual buys and sells quickly, though clearly there is considerable more volatility with this strategy. These investors have created an industry around buying and selling stocks on a very short-term basis that can range from a few minutes to a few hours but rarely overnight. While many day traders are bank or investment employees who specialize in fund management and equity investment, casual, at home traders have taken advantage of electronic trading and margin trading. Day trading, in particular for home traders, is very risky as the traders may have inadequate risk capital, have poor trading discipline, or be incompetent with money management.

Second, as stated earlier, the other method of issuing paper is by selling them to a dealer who then sells them in the market.


Defaults

When a business is established and able to build a high credit rating, commercial paper is usually cheaper than a bank line of credit; however, companies often maintain bank links of credit as backups. One of the benefits of commercial paper is the rarity of defaults. Defaults on high quality commercial paper are rare as well.

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