Course work compilations for Banking and Finance

By: Precious Kerme Gayan

Date: October 2, 2015

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CONTENTS

I. INTRODUCTION ................................................................................................................. 2

II. DEFINITION OF CERTIFICATE OF DEPOSIT AND HOW IT WORKS .................. 3

III. HOW CDs WORK................................................................................................................. 4

a. Closing a CD ....................................................................................................................... 4

b. CD Refinance ...................................................................................................................... 5

IV. GENERAL GUIDELINES FOR INTEREST RATES ON CDS ...................................... 5

V. THE CD LADDERS STRATEGY ....................................................................................... 6

VI. TYPES OF CDS ..................................................................................................................... 7

a. Brokered CDs ..................................................................................................................... 7

i. Advantages of Brokered CDs ........................................................................................ 7

b. Non-callable CDs ................................................................................................................ 8

c. Callable CD......................................................................................................................... 8

i. What causes a callable CD to be called? ...................................................................... 8

ii. Risks of callable CDs ...................................................................................................... 8

d. Fixed-rate CDs. .................................................................................................................. 9

e. Step-up CDs ........................................................................................................................ 9

f. Zero-coupon CDs. ............................................................................................................ 10

g. Market-Linked CDs ......................................................................................................... 10

VII. TERMS AND CONDITIONS............................................................................................. 10

VIII.ADVANTAGES OF CDs ................................................................................................... 12

IX. DISADVANTAGES OF CDs .............................................................................................. 13

X. CRITICISM OF CDs .......................................................................................................... 13

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I. INTRODUCTION

One of the advantage of being financially wise and having a savings account or funds to invest is

that you can make your money work for you by earning interest. This is done through investment

in certificates of deposits. One can find CDs products at banks or credit unions. In fact, online

banks often offer some of the best options and highest CDs.

This paper gives a detail overview of Certificate of Deposit (CD) starting with a full definition and

explanation of the meaning of a CD and how it works. The paper further discussed in detail the

various types of CDs, “the CD Ladder strategy” that is the strategies CDs used, the advantages and

disadvantages of a CD and at its concluding stage, the paper also discussed criticisms that are made

on CDs.

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II. DEFINITION OF CERTIFICATE OF DEPOSIT AND HOW IT WORKS

Sold by financial institutions, certificates of deposits are low risk investments suitable for money

that you do not require for years or months. If you leave the money untouched throughout the

investment period, the financial institution will pay an interest rate that is slightly higher than

earnings in a savings account or money market.

CDs are similar to savings accounts in that they are insured and thus virtually risk free; they are

"money in the bank." In the USA, CDs are insured by the Federal Deposit Insurance

Corporation (FDIC) for banks and by the National Credit Union Administration (NCUA) for credit

unions. They are different from savings accounts in that the CD has a specific, fixed term (often

monthly, three months, six months, or one to five years) and, usually, a fixed interest rate. It is

intended that the CD be held until maturity, at which time the money may be withdrawn together

with the accrued interest.

In exchange for keeping the money on deposit for the agreed-on term, institutions usually grant

higher interest rates than they do on accounts from which money may be withdrawn on demand,

although this may not be the case in an inverted yield curve situation. Fixed rates are common, but

some institutions offer CDs with various forms of variable rates. For example, in mid-2004,

interest rates were expected to rise, many banks and credit unions began to offer CDs with a

"bump-up" feature. These allow for a single readjustment of the interest rate, at a time of the

consumer's choosing, during the term of the CD. Sometimes, CDs that are indexed to the stock

market, the bond market, or other indices are introduced.

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III. HOW CDs WORK

CDs typically require a minimum deposit, and may offer higher rates for larger deposits. The best

rates are generally offered on "Jumbo CDs" with minimum deposits of $100,000.

The consumer who opens a CD may receive a paper certificate, but it is now common for a CD to

consist simply of a book entry and an item shown in the consumer's periodic bank statements; that

is, there is often no "certificate" as such. Consumers who wish to have a hard copy verifying their

CD purchase may request a paper statement from the bank or print out their own from the financial

institution's online banking service.

a. Closing a CD

Withdrawals before maturity are usually subject to a substantial penalty. For a five-year CD, this

is often the loss of six months' interest. These penalties ensure that it is generally not in a holder's

best interest to withdraw the money before maturity—unless the holder has another investment

with significantly higher return or has a serious need for the money.

Commonly, institutions mail a notice to the CD holder shortly before the CD matures requesting

directions. The notice usually offers the choice of withdrawing the principal and accumulated

interest or "rolling it over" (depositing it into a new CD). Generally, a "window" is allowed after

maturity where the CD holder can cash in the CD without penalty. In the absence of such

directions, it is common for the institution to roll over the CD automatically, once again tying up

the money for a period of time (though the CD holder may be able to specify at the time the CD is

opened not to roll over the CD).

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b. CD Refinance

Insured CDs are required by the Truth in Savings Regulation DD to state at the time of account

opening the penalty for early withdrawal. It has been generally accepted that these penalties cannot

be revised by the depository prior to maturity. However, there have been cases in which a credit

union modified its early withdrawal penalty and made it retroactive on existing accounts. The

second occurrence happened when Main Street Bank of Texas closed a group of CDs early without

full payment of interest. The bank claimed the disclosures allowed them to do so.

The penalty for early withdrawal is the deterrent to allowing depositors to take advantage of

subsequent enhanced investment opportunities during the term of the CD. In rising interest rate

environments the penalty may be insufficient to discourage depositors from redeeming their

deposit and reinvesting the proceeds after paying the applicable early withdrawal penalty. The

added interest from the new higher yielding CD may more than offset the cost of the early

withdrawal penalty.

IV. GENERAL GUIDELINES FOR INTEREST RATES ON CDS

A larger principal should receive a higher interest rate, but may not.

A longer term will usually receive a higher interest rate, except in the case of an inverted yield

curve (i.e. preceding a recession)

Smaller institutions tend to offer higher interest rates than larger ones.

Personal CD accounts generally receive higher interest rates than business CD accounts.

Banks and credit unions that are not insured by the FDIC or NCUA generally offer higher

interest rates.

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V. THE CD LADDERS STRATEGY

While longer investment terms yield higher interest rates, longer terms also may result in a loss of

opportunity to lock in higher interest rates in a rising-rate economy. A common mitigation strategy

for this opportunity cost is the "CD ladder" strategy. In the ladder strategies, the investor distributes

the deposits over a period of several years with the goal of having all one's money deposited at the

longest term (and therefore the higher rate), but in a way that part of it matures annually. In this

way, the depositor reaps the benefits of the longest-term rates while retaining the option to re-

invest or withdraw the money in shorter-term intervals.

For example, an investor beginning a three-year ladder strategy would start by depositing equal

amounts of money each into a 3-year CD, 2-year CD, and 1-year CD. From this point on, a CD

will reach maturity every year, at which time the investor would re-invest at a 3-year term. After

two years of this cycle, the investor would have all money deposited at a three-year rate, yet have

one-third of the deposits mature every year (which can then be reinvested, augmented, or

withdrawn).

The responsibility for maintaining the ladder falls on the depositor, not the financial institution.

Because the ladder does not depend on the financial institution, depositors are free to distribute a

ladder strategy across more than one bank, which can be advantageous as smaller banks may not

offer the longer terms found at some larger banks. Although laddering is most common with CDs,

this strategy may be employed on any time deposit account with similar terms.

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VI. TYPES OF CDS

a. Brokered CDs

This class of CD is usually purchased at a local bank branch. Many banks are highly motivated to

gain depositors beyond local, walk-in customers. As a result, many banks use the nationwide

brokerage community for distribution of CDs. CDs obtained in this manner are called “brokered

CDs.” Like CDs purchased at a bank or any other bank deposit, brokered CDs are covered by

Federal Deposit Insurance Corporation (FDIC) insurance.

Brokered CDs are simply CDs issued by banks, purchased in bulk by securities firms, and sold to

clients through financial professionals. CD transactions can be executed within a brokerage

account and investors receive an account statement detailing their brokered CD holdings instead

of physical certificates.

i. Advantages of Brokered CDs

Brokered CDs are available from many institutions across the United State and other countries.

Investors can choose from a wide selection of maturities and coupon frequencies to find a CD

suited to their particular investment requirements.

Brokered CDs are available in a variety of structures, such as non-callable (“bullet”), callable,

fixed-rate, step-up, market index-linked, and zero-coupon. Interest payments may be made on

either a monthly, quarterly, or semiannual basis, or at maturity in the case of zero-coupon CDs and

issues of one year or less.

Most brokered CDs have a “survivor’s option,” which is designed to protect estate assets. This

provision may allow for the full withdrawal of the principal and interest in the event of the death

or adjudication of incompetence of the beneficial owner, regardless of whether the current market

value has fallen.

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b. Non-callable CDs

A non-callable, or bullet, CD is the most basic type of brokered CD and has a fixed (bullet)

maturity date. Maturities generally range from three months to 10 years. Non-callable CDs are

available in fixed-rate or zero-coupon structures. The non-callable or “lockout” period is the time

during which an issuer cannot call the CD, is usually one to five years. Callable CDs are generally

available in fixed-rate, step-up, and zero-coupon structures.

c. Callable CD

A bank that issues this kind of CD can recall it after a set period, returning your deposit plus any

interest owed. Banks do this when interest rates fall significantly below the rate initially offered.

To make this type of CD attractive, banks typically pay a higher interest rate. These accounts are

typically offered through brokerages.

i. What causes a callable CD to be called?

After the initial non-callable period, the issuing bank has the right, but not the obligation, to call

the CD for any reason before its stated maturity. As a practical matter, an issuer will generally

decide to call a CD when it can issue a new CD at a lower rate than the existing CD. Investors

considering an investment in callable CDs should note that it is unlikely that they would be able

to replace their called CD with one that pays an equivalent interest rate under this scenario.

ii. Risks of callable CDs

Callable CDs are typically issued with longer maturities. Hence, investors should purchase a

callable CD only if they understand that the timing of the return of principal may be uncertain due

to the call feature and may, in fact, be at the maturity date. Callable CDs may be paid off before

maturity as a result of a call by the issuer and, in certain cases, the total return may be less than the

yield that the CD would have earned had it been held to maturity. As noted earlier, if the issuer

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calls the CD, investors may be unable to reinvest the funds at the rate of the original CD. Investors

should be prepared to hold the CD until maturity in the event it is not called.

If a callable CD is sold before maturity, the value of the CD will be subject to full market

considerations, including, but not limited to, interest rate changes, which could result in a

significant loss from the initial investment amount. This is true of all brokered CDs. However,

since callable CDs tend to have longer maturities, their price sensitivity to interest rate changes is

greater

d. Fixed-rate CDs.

These are the simplest, and thus the most common, type of CD structure in the marketplace. Fixed-

rate CDs can be issued as either non-callable (bullet) or callable. The CD’s coupon, or interest rate,

is set at issuance and remains the same until maturity or until the CD is called by the issuing bank.

Interest payments are made on either a monthly, quarterly, or semiannual basis, or at maturity for

issues of one year or less. Investors who require consistent income may find fixed-rate CDs

appropriate.

e. Step-up CDs

The step-up CD is typically issued only in callable form. It provides a variation on the simple

fixed-rate CD by offering a predetermined schedule of coupon rates, which begins somewhat

below those of current fixed-rate CDs and gradually increases over a specified time frame. The

coupon may step-up only once, or as often as annually, until the issuer calls the CD or the CD

matures.

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f. Zero-coupon CDs.

For investors who do not require current income, zero-coupon CDs (ZCDs) may be worth

investigating. ZCDs are available in bullet or callable form. With ZCDs, there are no coupon

payments. Instead, the CDs are issued at a deep discount to their face value (“par”) and then

gradually accumulate interest due until they reach par at maturity and are retired. With ZCDs, there

is no need to reinvest periodic coupon payments. This is a plus for investors who are saving for

future expenditures such as education or retirement. Note that interest earned on ZCDs is taxable

each year, even though it is not received until maturity.

g. Market-Linked CDs

MLCDs provide investors the opportunity to participate in the potential gains of the equity market

in a way that may allow them to reduce the risk associated with equity investing. If held to maturity,

100% of the investor’s principal investment is protected, but if sold before maturity, the CDs may

be worth less than the initial investment. The MLCD’s rate of return is generally tied to the

performance of an underlying equity index, such as the S&P 500.4 MLCDs may appeal to investors

who are seeking a potentially greater return than a CD could provide and who are planning to hold

the investment to maturity

VII. TERMS AND CONDITIONS

There are many variations in the terms and conditions for CDs.

The federally required "Truth in Savings" booklet, or other disclosure document that gives the

terms of the CD, must be made available before the purchase. Employees of the institution are

generally not familiar with this information only the written document carries legal weight. If the

original issuing institution has merged with another institution, or if the CD is closed early by the

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purchaser, or there is some other issue, the purchaser will need to refer to the terms and conditions

document to ensure that the withdrawal is processed following the original terms of the contract.

The terms and conditions may be changeable. They may contain language such as "We can

add to, delete or make any other changes ("Changes") we want to these Terms at any time."[4]

The CD may be callable. The terms may state that the bank or credit union can close the CD

before the term ends.

Payment of interest. Interest may be paid out as it is accrued or it may accumulate in the CD.

Interest calculation. The CD may start earning interest from the date of deposit or from the

start of the next month or quarter.

Right to delay withdrawals. Institutions generally have the right to delay withdrawals for a

specified period to stop a bank run.

Withdrawal of principal. May be at the discretion of the financial institution. Withdrawal

of principal below a certain minimum—or any withdrawal of principal at all—may require

closure of the entire CD. A US Individual Retirement Account CD may allow withdrawal

of IRA Required Minimum Distributions without a withdrawal penalty.

Withdrawal of interest. May be limited to the most recent interest payment or allow for

withdrawal of accumulated total interest since the CD was opened. Interest may be calculated

to date of withdrawal or through the end of the last month or last quarter.

Penalty for early withdrawal. May be measured in months of interest, may be calculated to be

equal to the institution's current cost of replacing the money, or may use another formula. May

or may not reduce the principal—for example, if principal is withdrawn three months after

opening a CD with a six-month penalty.

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Fees. A fee may be specified for withdrawal or closure or for providing a certified check.

Automatic renewal. The institution may or may not commit to sending a notice before

automatic rollover at CD maturity. The institution may specify a grace period before

automatically rolling over the CD to a new CD at maturity. Some banks have been known to

renew at rates lower than that of the original CD

VIII. ADVANTAGES OF CDs

Easy to obtain

CDs are easy to get. One can simply walk into your bank or credit union and buy them over the

counter. Minimum investments at many institutions are $500 to $1,000, but some banks have no

minimum. If you have money in an existing savings account, you can transfer it to a CD. You can

also buy CDs through a brokerage that acts as a middleman between you and issuing banks.

Brokered CDs may offer a higher interest rate because of volume purchases by the brokerage.

Price of safety

The price of CD safety is an interest rate that's typically lower than what you can get with

somewhat riskier investments. These include corporate bonds and preferred stock from companies

with credit ratings of BBB and above, bond mutual funds, and fixed annuities from top-rated life

insurance companies. As of 2012, many banks were paying up to 1 percent on one-year CDs and

up to 1.75 percent on five-year CDs. The low- to moderate-risk alternatives to a CD paid 0.5

percent to 2 percent more than this. The fixed interest rate on CDs can work against you. If market

interest rates rise substantially, you will be locked into the lower rate.

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In summary, investments offer numerous benefits to an investor. For instance, they offer high

returns. These investments produce a high return than the conventional deposit accounts, yet they

lack the risks and volatility related to annuities, stocks, and other investment types. Additionally,

they are a secure form of investment. For safety purposes, it is safe to verify that the Federal

Deposit Insurance Corporation has insured your investment. Additionally, these investments are

almost risk-free. This is because you will obtain a predetermined return rate.

IX. DISADVANTAGES OF CDs

These investments have a high outlay in terms of initial investment. The minimum amount

necessary to open a CD is typically higher than what you require for a savings account.

Additionally, you require a considerable initial investment in order to obtain high interest rates.

The other drawback is that you obtain minimal returns as an investment instrument. Short-term

deposits provide low return rates than long terms. Moreover, this investment will not provide

considerable returns, unlike most investment types.

A CD is an account type that entitles you to obtain an interest. Banks and other financial institutions

typically issue this financial product. It offers various benefits including high returns.

Nevertheless, it features various drawbacks such as a high initial investment. Therefore, you

should weigh the benefits and drawbacks before investing in this product.

X. CRITICISM OF CDs

CD interest rates closely track inflation. For example, in one situation interest rates may be 15%

and inflation may be 15%, and in another situation interest rates may be 2% and inflation may be

2%. Of course, these factors cancel out, so the real interest rate is the same in both cases.

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In this situation, it is a misinterpretation that the interest is an increase in value. However, to keep

the same value, the rate of withdrawal must be the same as the real rate of return, in this case, zero.

People may also think that the higher-rate situation is "better", when the real rate of return is

actually the same.

Also, the above does not include taxes. When taxes are considered, the higher-rate situation above

is worse, with a lower (more negative) real return, although the before-tax real rates of return are

identical. The after-inflation, after-tax return is what's important.

Author Ric Edelman writes: "You don't make any money in bank accounts (in real economic

terms), simply because you're not supposed to. On the other hand, he says, bank accounts and CDs

are fine for holding cash for a short amount of time.

Even if CD rates track inflation, this can only be the expected inflation at the time the CD is bought.

The actual inflation will be lower or higher. Locking in the interest rate for a long term may be

bad (if inflation goes up) or good (if inflation goes down). For example, in the 1970s, inflation

increased higher than it had been, and banks were slow to raise their interest rates. This does not

much affect a person with a short note, since they get their money back, and they can go somewhere

else (or the same place) that gives a higher rate. But longer notes are locked in their rate. This gave

rise to amusing nicknames for CDs. A bit later, the opposite happened, where inflation was

declining. This does not greatly help a person with a short note, since they shortly get their money

back and they are forced to reinvest at a new, lower rate. But longer notes become very valuable

since they have a higher interest rate.

However, this applies only to "average" CD interest rates. In reality, some banks pay much lower

than average rates, while others pay much higher rates (two-fold differences are not unusual, e.g.,

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2.5% vs 5%). In the United States, depositors can take advantage of the best FDIC-insured rates

without increasing their risk.

Investors should be suspicious of an unusually high interest rate on a CD. Allen Stanford used

fraudulent CDs with high rates to lure people into his Ponzi scheme.

Finally, the statement that "CD interest rates closely track inflation" is not necessarily true. For

example, during a credit crunch banks are in dire need of funds, and CD interest rate increases may

not track inflation.

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