Barbican Consulting Limited
Certificates of Deposit
Certificates of Deposit - What they are
When you make a bank deposit you normally have to wait until the deposit maturity date before you can access your funds and receive interest. This is not always desirable particularly if you need access to your money before the maturity date. CDs help overcome this difficulty.
CDs are negotiable or tradable bank deposits. Instead of placing a deposit you buy a CD. It is the financial instrument that evidences the deposit you have made. It normally takes the form of an electronic book entry but in certain circumstances, paper certificates can be issued. To get access to your money before the maturity date requires selling your CD to a third party. Provided you can find a buyer a CD offers you more flexibility than a traditional deposit. The majority of CDs are bought and sold by financial institutions although in a few circumstances, retail investors also purchase CDs.
CDs are issued under a proper legal framework known as a CD programme. There will be an information memorandum or prospectus that provides details about the issuer and the currencies and amounts that can be issued. Most CDs are sold directly by banks from their money market dealing desk. It’s just another instrument the bank can use in order to borrow short-term money. The process is straightforward forward the investor and issuer agree the amount, maturity date, currency and interest rate. The deal is agreed and the settlement process is normally by way of delivery against payment.
Interest-bearing or discounted
The CD can be interest-bearing or discounted. Interest-bearing CDs are just like bank deposits and pay interest on a simple basis. Here is an example:
Principal invested: $5,000,000
Interest rate: 4%
Days: 91
Interest: $50,555.55
Principal + interest: $5,050,555.55 (repaid on maturity)
Discounted CDs are slightly different. The principal repayment is discounted. Here is an example using the same interest rate:
Principal repaid: $5,000,000
Interest rate: 4%
Days: 91
Principal invested: $4,949,950.50
The principal invested is calculated by using a discount factor. In this case the discount factor is:
1 / (1 + 0.04 x 91 / 360) = 0.989901
$5,000,000 x 0.9899901 = $4,949,950.50
From a settlement perspective the price of the discounted CD will be:
$4,949,950.50 / $5,000,000 = 98.999010% of par value
For settlement departments, it is important that this is agreed or the trade will not settle correctly.
If you are a little puzzled by the discounted CD perhaps this will help:
Principal invested: $4,949,950.50
Principal repaid: $5,000,000.00
Interest: $50,049.50
Days: 91
The interest rate you earn is:
$50,049.50 / $4,949,950.50 x 360 / 91 = 4.00%
Credit Risk
The CD is a direct obligation of the issuer. This means that the main risk for the investor is the credit risk of the issuing firm. Will they have sufficient money to repay capital and interest on the maturity date?
For this reason an investor in CDs is advised to make the necessary credit assessment on the issuer. In wholesale markets any dealer buying a CD must have sufficient credit line in place before agreeing to purchase a CD.
Interest Rate Risk
CDs provide the investor with a fixed rate of return over the investment period. Therefore the market value of the CD will alter with changes in short term interest rates.
If you recalculate the value of the earlier discounted CD but instead of using a 4% interest rate you use a 5% rate then the results are as follows:
Principal invested: $5,000,000 x 0.9875188 = $4,937,594.29 or 98.7518859%
What does this mean?
It means that if you had invested in the CD at 4% and interest rates had gone up to 5% the same day your investment would have a market value that was $12,356.21 less than the amount you had paid for it.
Does that matter?
Yes. If you marked your investment to market this would be a real loss. If you decided to sell your investment you would lose money. And even if you don’t mark-to-market your investment return is now lower than the current market rate.
Whilst interest rates are unlikely to move 1% in a day the cumulative affect of small changes can lead to gains and losses that are surprisingly large.
The simple rule is if interest rates rise the value of your CD falls and vice versa.
What influences the size of your risk?
Four things:
The amount you have invested
The amount interest rates change by
The number of days before the CD matures (the longer this period the more risk you have, to see the numbers try the above example but substitute 182 days in place of 91 days).
The level of interest rates. (This is rather technical but when interest rates are low a small change in interest rates has a much greater effect on the value of the CD than when interest rates are high).
Liquidity
So far we have assumed that CD markets are liquid. This implies that any sellers can find buyers and the transaction cost (bid-ask spread is relatively small). Pre 2007 this was the case, prime bank CDs were relatively easy to buy and sell and many firms classified them as liquid assets. Post 2007 this has become more subjective. Money market liquidity is much more fragile. Finding a buyer for your CD is more difficult and bid-offer spreads are wider so the transaction cost of liquidation is greater. Do CDs count as liquid assets? That depends on your regulator. CDs with maturities shorter than three months issued by prime bank names with good credit standings should be liquid. Longer dated CDs particularly those issued by weaker firms will be much harder to sell.
So just how do you determine what is liquid? The simple answer is to test the market-how easy is it to get a dealing price and what happens if you try to trade at that price?
CD Trading
Many CDs are held until maturity but suppose you want to buy or sell a CD that was issued some time ago how do you determine what it is worth?
It’s all a matter of discounting the cash flow. Calculate how much the CD holder receives on the maturity date. Then discount this cash flow using the appropriate interest rate and the number of days the CD has until it matures. Have you spotted the difficulty? It’s the interest rate at which you discount the CD. What’s the answer?
As an alternative to a bank deposit it is tempting to discount the CD at the prevailing Libor rate that matches the remaining term of the CD. This may well be a starting point but will not necessarily provide you with an accurate answer.
The rate used needs to take into account the maturity of the CD, the credit standing of the issuer and the liquidity conditions in the current market. Dealers have an advantage. They see where current deals are priced. As a rule of thumb, the weaker the credit standing of the issuer and the longer the CD has until its maturity the harder this assessment will be.
Ultimately the price will be what the market will pay. In this respect, you may find it advantageous to obtain more than one quote it could save you money!
First published by Barbican Consulting Limited 2009