Question

6. Assume that commercial paper maturing in 75 days, with a par value of $1,000,000, currently sells for a price of $995,000.

A. If you purchase this commercial paper today:

• What is your expected holding period return? • What is your (expected) annualized yield? What is the effective annual return on this investment?

B) When comparing the annualized yield on this security to the annualized yield on a 75-day T-Bill:

• What is one reason why you would expect the commercial paper yield to be higher than the T-Bill yield? Explain (but in one sentence).

• What is one reason why you would expect the commercial paper yield to be only slightly higher than the T-Bill yield? Explain (but in one sentence).

Answer 1

B)When comparing the annualized yield on this commercial paper to the annualized yield on a 75-day T-Bill, commercial paper yield will be higher than the T-Bill yield as a company that issues commercial bills does not have the same ability to generate cash inflow because it does not have the same power over consumers and same rules and regulations that a government possesses as in case of T-bills are issued by the Govt itself.So, commercial bills and T-bills differ in the credit quality of the issuing authorities due to which there is a greater chance that the creditor will be unable to meet its debt obligation in case of T-bills.So,A higher yield acts as compensation for investors who choose the higher-risk commercial bills.

Commercial paper's yield will be slightly higher than that of T-bills because it does not create that sense of security to the investors as can be in case of Govt issuer and so commercial paper investment is riskier than T-bills and so to match with that level of risk slightly higher return needs to be provided in order to attract the investors.