5.2.2The market for certicates of deposit

A certicate of deposit (CD) states that a deposit has been made with a bank for

a xed period of time, at the end of which it will be repaid with interest. It is, in

effect, a receipt for a time deposit. This explains, incidentally, why CDs appear in

denitions of the money supply such as M4. It is not the certicate as such that we

wish to include but the underlying deposit, which is a time deposit just like all other

time deposits that appear in such denitions. An institution is said to ‘issue’ a CD

when it accepts a deposit and to ‘hold’ a CD when it itself makes a deposit or buys

a certicate in the secondary market. From an institution’s point of view, therefore,

issued CDs are liabilities; held CDs are assets.

A CD might be described thus, ‘£50,000 three-month CD at 10 per cent’. This

would mean the holder would receive £50,000 plus 0.25 10 per cent, i.e. £51,250,

at the end of the period. The advantage to the depositor is that the certicate is

tradable so that, although the deposit is made for a xed period, he can have use of

the funds earlier by selling the certicate to a third party at a price which will reect

the period to run to maturity and the current level of interest rates. The advantage

to the bank is that it has the use of a deposit for a xed period but, because of the

exibility given to the lender, at a slightly lower price than it would have had to pay

for a normal time deposit.

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5.2 The ‘parallel’ markets

Unlike bills, CDs are priced on a yieldbasis. The rate of interest paid on CDs is often

linked to interbank rate. If LIBOR is 9.75 per cent, for example, the CD described above

might be paying 10 per cent because it is quoted as paying LIBOR plus 25 basis points.

In the circumstances, the 10 per cent payable at maturity is similar to the coupon

rate (c) on a conventional bond, except that the coupon is paid just once, at maturity.

The maturity, or redemption value (R) of the CD if held to maturity will be:

RD(1 c · n)

(5.4)

where Dis the value of the initial deposit and nis the original maturity expressed

as a fraction of a year. Thus, at redemption, our £50,000 CD above will be worth:

£50,000 (1 0.1(0.25)) £51,250

The market price of the CD now is found by discounting the redemption value by the

rate of interest currently available on similar assets, adjusted for the residual maturity.

As an exercise we can just check that if we are pricing this CD on the day of issue and

short-term interest rates are the same as the coupon rate on the CD (10 per cent), then

the value of the CD now is £50,000, the price we have paid for it. The formula is:

	R
P		(5.5)
	1 i · n

and the result is £51,250 (1 0.1(0.25)) £50,000.

Notice that if all else remains the same, the market price will rise as the residual

maturity shortens. We saw this with bills and it happens here for the same reason.

Because the CD is issued with a xed rate of interest, its maturity value is xed from

the outset. The shorter the period one has to wait for the £1,250 prot, the higher the

rate of return one earns. But if interest rates generally are unchanged, this cannot

be. The rate of return cannot be out of line with returns on other similar assets. And

what keeps it in line is the price which people are willing to pay for the CD as it

nears maturity. Exercise 5.2 asks you to calculate the price of this same CD when

there are just 36 days left to maturity.

Exercise 5.2

(a)Find the price of a three-month £50,000 CD, paying 10 per cent, if it has 36 days to maturity and short-term interest rates are 10 per cent.

(b)Find the price of this same CD if short-term interest rates fall to 8 per cent.

Answers at end of chapter

Another similarity with bills (again because the CD is a xed-interest instrument)

is that changes in market interest rates will cause a change in price. We can see this

by using eqn 5.5 again. Suppose that market rates rise to 12 per cent (on the same day

that the CD is issued!). Then:

P£51,250 (1 0.12(0.25)) £51,250 1.03 £49,757

If we needed to sell our £50,000 CD instantly, we should be able to get only

£49,757 for it.

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Chapter 5 • The money markets

Finally, given the pricing equation (5.5), it follows that if we know the current

market price of a CD of given size and coupon, and given maturity, we can nd

its current yield. This is done by taking the difference between the market price

and the redemption value, as a percentage of the purchase price, and adjusting that

percentage to an annualised rate:

ARD	1
i1·		(5.6)

CPF	n

Notice (by rearranging the terms) that eqn 5.5 is exactly equivalent to eqn 5.2, the

equation for calculating the rate of return on a yield basis rather than a discount

basis. As we said at the beginning of this section, the difference in quotation method

is the major difference between a bill and a CD.

Exercise 5.3

A three-month CD for £100,000 at 6 per cent matures in 73 days. It is currently trading at £99,000. What rate of return is this CD currently offering?

Answer at end of chapter

Certicates of deposit are another means of short-term, wholesale lending and

borrowing. Three- and six-month maturities are common. Some CDs are issued for

one year and even for two years but the market for these is comparatively thin. This

has led to the practice of banks issuing ‘roll-over’ CDs, i.e. six-month CDs with a

guarantee of further renewal on specied terms. The minimum value is £50,000.

A market in CDs began in 1966 with dollar certicates. The rst sterling CDs

were traded in 1968 when foreign banks, some merchant banks and discount houses

began issuing and holding CDs. They were quickly joined by other banks, including

the clearing banks, in 1971. During the 1970s the market developed dramatically. As

we saw in earlier chapters, CDs are now issued by a wide variety of banks and since

1983 by building societies. It is quite common for a bank both to have issued and to

hold CDs, though normally of differing maturities. It will issue CDs with a maturity

expected to coincide with a liquidity surplus and hold CDs expected to mature at a

time of shortage.