Question

Give TWO reasons why the interest rate for a given maturity in the commercial paper market is typically lower than the interest rate for the same maturity in the Eurodollar market.

Answer 1

Euro-dollar

By Euro-dollar is meant all U.S. dollar deposits in banks outside the United States, including the foreign branches of U.S. banks. A Euro-dollar is, however, not a special type of dollar. It bears the same exchange rate as an ordinary U.S. dollar has in terms of other currencies.

Euro-dollar transactions are conducted by banks not resident in the United States. For instance, when an American citizen deposits (lends) his funds with a U.S. Bank in London, which may again be used to make advances to a business enterprise in the U.S., then such transactions are referred to as Euro-dollar transactions. All Euro-dollar transactions are, however, unsecured credit.

Euro-dollars have come into existence on account of the Regulation issued by the Board of Governors of the U.S. Federal Reserve System, which does not permit the banks to pay interest to the depositors above a certain limit.

As such, banks outside the United States tend to expand their dollar business by offering higher deposit rates and charging lower lending rates, as compared to the banks inside the U.S. Increase or decrease in the potential for Euro-dollar holdings, however, depends, directly upon U.S. deficits and surplus, respectively.

The Euro-dollar market attracts funds by offering high rates of interest, greater flexibility of maturities and a wider range of investment qualities.

Commercial paper

Commercial paper is a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities. Maturities on commercial paper typically last several days, and rarely range longer than 270 days. Commercial paper normally has Zero Coupan Rate & is usually issued at a discount from face value and reflects prevailing market interest rates.

A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months, or 270 days, making it a very cost-effective means of financing. Although maturities can go as long as 270 days before coming under the purview of the SEC, maturities for commercial paper average about 30 days, rarely reaching that threshold. The proceeds from this type of financing can only be used on current assets, or inventories, and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.

Reasons why the interest rate for a given maturity in the commercial paper market is typically lower than the interest rate for the same maturity in the Eurodollar market -

From above information it is clear that

1) Banks outside the United States offer higher deposit rates and charge lower lending rates, as compared to the banks inside the U.S to expand their dollar business.

2) Commercial Paper is an unsecured short term debt issued at discout instead of paying Interest, making it cost effective for the Comapany providing it to meet its short term cash crunch. And hence is issued at much less interest rate than Eurodollar.