Definition of Short-Term Financing

In this section, we will briefly describe some of the common short-term funding instruments such as commercial paper (CP), bankers’ acceptances (BAs) and Certificates of Deposit (CDs). In addition, there are short-term bank loans ranging in maturity from overnight to one year.

i) Commercial Paper (CP)

Commercial Paper is a corporate short-term, unsecured promissory note issued on a discount to yield basis. It can be regarded as a corporate equivalent of CD (Certificate of Deposit) which is an interbank instrument.

Commercial paper maturities generally do not exceed 270 days. Issuers usually roll over the issue and use the proceeds from the new issue to retire the old issue. The issue is normally placed through CP dealers or, in a few cases, large corporations have their own sales force. Commercial paper represents a cheap and flexible source of funds especially for highly rated borrowers, cheaper than bank loans. For investors, it is an attractive short- term investment opportunity compared to a time deposit with a bank.

In addition to the high credit reputation of the borrowers, most CP programmes also require a back-up credit line from a commercial bank, covering at least 50% more often nearly 100% of the issue. While CPs are negotiable, secondary markets tend to be not very active since most investors hold the paper to maturity.

The US has the largest and long-established dollar CP market. In recent years, it has dwarfed the markets for Certificates of Deposit and Bankers’ Acceptances. It is used extensively by US corporations as well as some non-US corporations. The emergence of the Euro Commercial Paper (ECP) is much more recent. Investors in CP consist of money market funds, insurance companies, pension funds, other financial institutions and corporations with short-term cash surpluses.

A Certificate of Deposit (CD)

CD is a negotiable instrument evidencing a deposit with a bank. Unlike a traditional bank deposit which is non-transferable, a CD is a marketable instrument so that the investor can dispose off it in the secondary market when cash is needed. The final holder is paid the face value on maturity along with the interest. CDs are issued in large denominations $100,000 or equivalent or higher – and are used by commercial banks as short-term funding instruments. Occasionally, CDs with maturity exceeding one year are issued. When the maturity is less than a year, interest is paid along with redemption of principal. For maturity longer than a year, interest may be paid semi-annually.

Euro CDs are issued mainly in London by banks. Interest on CDs with maturity exceeding a year is paid annually rather than semi-annually. There are floating rate CDs with maturities normally ranging from 18 months to five years on which interest rate is periodically reset, indexed to LIBOR, Federal Reserve CD composite rate, Treasury Bill rate and so forth.

Banker’s Acceptances (BAs)

BAs are instruments widely used in the US money market to finance domestic as well as international trade. In a typical international trade transaction, the seller (exporter) draws a time or usance draft on the buyer’s (importer’s) bank. On completing the shipment, the exporter hands over the shipping documents and the letter of credit issued by the importer’s bank to its (exporter’s) bank. The exporter gets paid the discounted value of the draft. The exporter’s bank presents the draft to the importer’s bank which stamps it as “accepted”. A banker’s acceptance is created. The exporter’s bank may hold the draft units portfolio ask the importer’s bank to rediscount it or sell it as a money market instrument.

In addition to those securitized instruments, short-term bank loans are also available. The Eurocurrencies market is essentially an interbank deposit and loans market. Loans ranging in maturity from overnight to one year can be arranged with minimal formalities. Interest rates are indexed to LIBOR.