MONEY MARKET CREDIT
Commercial Paper: Large, well established companies sometimes borrow on a short term through commercial paper and other money instruments. Commercial paper represents an unsecured, short-term, negotiable promissory note sold in the money market. Because these notes are a money market instrument, only the most creditworthy companies are able to use commercial paper as a source of short term financing.
The commercial paper market is composed of two parts: the dealer market and the direct placement market Industrial firms, utilities and medium sized finance companies sell commercial paper through dealers. The dealer organization is composed of a half-dozen major dealers who purchase commercial paper from the issuer and, in turn, sell it to investors. The typical commission a dealer earns is â…› % and maturities on dealer placed paper generally range from 30 to 90 days. The market is highly organized and sophisticated; paper is generally sold in minimum denominations of $100,000. Although the dealer market has been characterized in the past by the significant umber of issuers who borrowed on a seasonal basis, the trend is definitely toward financing on revolving or more permanent basis.
A number of large finance companies such as General Motors Acceptance Cooperation (GMAC), bypass the dealer organization in favor of selling their paper directly to investors. These issuers tailor both the maturity and the amount of the notes to the needs of investors, mostly large corporation with excess cash. Maturities on directly on directly placed domestic paper can range from as little as a few days up to 270 days. Unlike many industrial issuers, finance companies use the commercial paper market as a permanent source of funds. Both dealer placed and directly placed paper is rated according to its quality by one or more of the independent rating agencies — Moodyâ€™s, Standard & Poorâ€™s, Duff & Phelps, and Fitchâ€™s. The top ratings are P-1, A-1, D-1, and F-1 for the four agencies, respectively. Only grade 1 and grade 2 papers find favor in the market.
The principal advantage of commercial paper as a source of short term financing is that it is generally cheaper than a short term business loan from a commercial bank. Depending on the interest rate cycle, the rate on commercial paper may be as much as several percent lower than the prime rate for bank loans to the highest quality borrowers. For most companies, commercial paper is a supplement to bank credit. In fact, commercial paper dealers require borrowers to maintain lines of credit at banks in order to backstop the use of commercial paper. This provides added assurance that commercial paper borrowings can be paid off. On the whole however, the growth of the commercial paper and other money markets has been at the expense of bank borrowings. The market share of total corporate enjoyed by banks has declined over time.
Letter of Credit (L/C): A promise from a third party (usually a bank) for payment in the event that certain conditions are met. It is frequently used to guarantee payment of an obligation. L/C is more commonly used in International Trade.