Certificate of Deposit - Explained
What is a Certificate of Deposit?
Written by Jason Gordon
Updated at October 2nd, 2021
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Table of Contents
What is a Certificate of Deposit?How Does a Certificate of Deposit Work?Academic Research on Certificate of DepositWhat is a Certificate of Deposit?
Certificate of Deposit is a financial document or contract offered by a financial institution normally with a fixed return over a particular period of time. US is the pioneer country that started issuing a Certificate of Deposit back in 1961. This financial security can be exchanged in a secondary market. With a Certificate of deposit, an investor is in a position to sell the securities before the maturity date although its liquidity is lower compared to other types of assets like shares.
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How Does a Certificate of Deposit Work?
CDs are the most commonly used for creating secured savings because of the low-interest rate. In addition to that, there are no fees attached to the investment. The CD limits the holder from withdrawing cash or funds in the CD with remitting a penalty. Usually, the holder is expected to leave the money with the bank for the whole term. It is also important to note that the terms for most CDs range between 3months to 5 years. In terms of getting the returns, the long-term CDs pay more than the short-term CDs, a situation which is always attributed to the risks of market uncertainty. CDs and banks are mostly insured by the Federal Deposit Insurance Corporation up to the tune of $250,000. There are a number of special CDs with special features, including:
- Step-Up Certificates of Deposit This enhances the yearly percentage increase in the yield after a given period.
- Bump-Up Certificate of Deposit - This type enables the owner to ask for a higher APY in the case that the bank adjusts its APYs on newly given CDs.In most cases, the rates can only be increased once or twice during the entire period. It is because of this benefit that these CDs carry a lower APY compared to fixed-rate CDs.
- Liquid Certificates of Deposit This gives the owner the capacity to withdraw their funds which enhances their liquidity because they can cash in the CD before maturity without paying a penalty. Because of the high liquidity, the CD mostly pays a lower APY compared to fixed-rate CDs.
- Jumbo Certificate of Deposit - This is one of the pioneer CD containing little investment or purchase price. Generally, they have a higher APY compared to non-jumbo CDs
- Individual Retirement Account Certificate of Deposit - It is one of the traditional CD that has the advantage of receiving favorable tax treatment.
The trading of Certificate of deposits is not very common except in Latin America countries where it remains very active. The holders of CDs tend to create a platform to check on some of the risks that come with investing in long-term CDs.Laddering, in this case, implies investing reasonably in Cds with different terms. Short term securities are usually reinvested in incrementally longer Cds as they mature. As a result of this, the holder is in a position to maintain staggered ownership of CD structure.
Academic Research on Certificate of Deposit
- The behaviour of certificate of deposit rates in the UK, Cuthbertson, K., Hayes, S., & Nitzsche, D. (1996). Oxford Economic Papers, 48(3), 397-414. This article investigates how certificate of deposit rates behave in the UK. A variety of tests on the expectation hypothesis (EH) are availed on the term structure. The results support the EH than previous studies which use longer maturities and yield many bonds unlike ones with shorter maturities.
- Asymmetric adjustment in the prime lendingdeposit rate spread, Thompson, M. A. (2006). Review of Financial Economics, 15(4), 323-329. This tries to examine the notion that bank lending rates change differently to rising versus decreasing market rates. The study employs models developed by Enders and Granger which concludes that there is an asymmetric adjustment in the deposit rate spread.
- The international transmission of Eurodollar and US interest rates: A cointegration analysis, Fung, H. G., & Isberg, S. C. (1992). Journal of Banking & Finance, 16(4), 757-769. Here, an error correction model is used to examine the link between Us and Eurodollar certificate of Deposit between the period of 1981 and 1983. Results indicate that there is a structural adjustment in the CD rates. There exists a direct causality in this case unlike in the case of reverse causality in the period of 1984-1988. Such results have been brought about as a result of the expansion of the Eurodollar market.
- Common Enterprise and Multiple Investors: A Contractual Theory for Defining Investment Contracts and Notes, Gordon III, J. D. (1988). Colum. Bus. L. Rev., 635. This paper talks about the theories for defining notes and investment contracts in common enterprise and multiple investors.
- After Reves v. Ernst & (and) Young, When Are Certificates of Deposit Notes Subject to Rule 10b-5 of the Securities Exchange Act, Quinn, R. W. (1990). Bus. Law., 46, 173. This section is dealing with the Securities Exchange Act and how the Certificate of Deposits are subject to the rules 10b-5 of that Securities Exchange Act.
- An economic analysis of bank-issued market-indexed certificate of depositAn option pricing approach, Hernndez, R., Brusa, J., & Liu, D. P. (2011). International Journal of Financial Markets and Derivatives, 2(3), 195-208. Here, the option pricing model is used to evaluate market-indexed Certificate of Deposits. It shows that the payoff of uncapped market-indexed Cd can be achieved by mixing zero coupon bond and a call option based on the index. We find out that the returns of giving a non-callable market-indexed is negative and equals the value of the put option. Hence, to make a profit, a market-indexed CD must possess at least one of the following; a cap on the return, a call provision, a guaranteed payoff less than par value, or a participation ratio lower than 100%.
- Interest rate setting and the Colombian monetary transmission mechanism, Amaya, G. (2005). This article addresses the setting of the interest rates in the Colombian monetary transmission and how it reflects on the interest rates. The study was conducted in the banking industry to find out how banks set their interest rates and how the policies affect those rates. It finds out that rates react strongly to inflation which is a long-term determinant of interest rates.
- Comovements of the prime rate, CD rate, and the S&P financial stock index, Ewing, B. T., Payne, J. E., & Forbes, S. M. (1998). Journal of Financial Research, 21(4), 469-482. The paper uses cointegration and error correction modeling techniques to find out the link between CD rates, prime lending rates, and the S&P Financial Stock Index. It is established that adjustments in deposit rates have a major impact on the price index of financial service sector more than changes in lending rates.
- The process of financial innovation, Silber, W. L. (1983). The American Economic Review, 73(2), 89-95. This section is laying bare the steps of financial innovation in the American Economy.
- Negotiable Certificate of Deposit: A New Monetary Instrument, Murdeshwar, M. L. (1970). Economic and Political Weekly, 1606-1608. The author tells us how the Negotiable Certificate of Deposits supplements avenues of savings currently available. The CDs also provide banks with additional sources of funds with attractive interest rates.
- Deposit insurance around the globe: Where does it work?, Asli Demirg-Kunt, A., & Kane, E. J. (2002). Journal of Economic Perspectives, 16(2), 175-195. The paper talks about the currently available deposit insurance in the world. It documents the differences that exist in deposit insurance designs worldwide and how specific designs affect banking stability, the market, and financial development. It encourages countries to adopt explicit deposit insurance.