Commercial paper is a short-term unsecuredpromissory notematuring in less than 270 days issued by banks for a fee on behalf ofcorporationsand other borrowers to raise funds from investors with idle cash. Commercial paper is a low-cost alternative to bank loans. Issuers areable toefficiently raise large amounts of funds quickly and without expensiveSecurities and Exchange Commission (SEC) registration by selling paper,eitherdirectly or through independent dealers, to a large and varied pool ofinstitutional buyers. Competitive, market-determined yields innoteswhose maturity and amounts can be tailored to specific needs, can beearned byinvestors in commercial paper. Commercial paper is usuallyissued indenominations of $100,000 or more. Therefore, smaller investors canonly investin commercial paper indirectly through money market funds or indirectlythroughtheir pension funds.
Notes must be of a type not ordinarily purchasedby thegeneral public. In practice, the denomination of commercial paper islarge:minimum denominations are usually $100,000, although face amounts aslow as$10,000 are available from some issuers. Typical face amounts areinmultiples of $1 million, because most investors are institutions. Issuerswill usually sell an investor the specific amount of commercial paperneeded.
Occasions in whichthe 2-year note trades below or well above the Fed Funds rate are usuallyshort-lived anticipations of an impending Fed rate cut or hike, respectively.
Expecting that higher interest rates lie ahead, bond investors prefer to stick with short-term notes whereas borrowers try toextend their maturities to benefit from low rates while they can — furthersteepening the yield curve.
The "flight to quality" or "safe-haven buying"drives international capital into short-term US Treasury securities — as in the aftermath of the "911", 2001 World Trade Centerattack.
In a swap, the BBB company would pay a fixed-rate to the AAA company while receiving a floating rate, which BBB company would useto cover payments on its short-term borrowings.
A company with higher rating (such as AAA) pays lower interest on(and/or has better access to) short-term credit than a company with a lower credit rating (such as BBB).
Dealers are typically large international commercial & investment banks with the financial means to act as a counterparty intermediate between fixed-rate payers and floating-rate payers.
IfParty B had simply issued more commercial paper it would be vulnerableboth to the risk that market rates would rise and to the risk that interest rates of its own commercial paper would rise above the marketrate.
Rather than issue more commercial paper, Party B issues a long-termbond at a fixed rate of interest and enters a swap whereby it receives fixed-rate payments to service thecost of the bond and pays a floating rate to Party A in return.
The $80 interest canbe called the coupon or coupon rate, a terminology arising from the time when bonds were usually certificates with the interest payments collected by cutting and redeeming coupons from the certificate.
While most short-term interest rates are subject to manipulation by national central banks, the inter-bank lending of Eurodollars by international banks seeking to manage their cash is perhaps the closest thingto an unregulated, free-market interest rate in the world.
Acceptances providea less expensive alternative to short-term bank loans for firms whosecredit-worthiness is not high enough to obtain commercial paper.
Thus, longer maturities are expected to show greater sensitivity/volatility for interest-ratechanges than shorter maturities, everything else being equal.
SEC regulationsallow registration exemption only if commercial paper is used to finance "current transactions" and if the maturity is not greaterthan 270 days.
An exact determination of sensitivity of bond price to interest rate change requires the use of calculus to determinesecond derivative to give convexity.