Certificates of deposit originated in the domestic US market (where they are directed primarily at the retail market). In the euromarket, however, CDs are very closely allied to interbank deposits.

A CD is a record evidencing the placement of a deposit with the CD issuer for a stated period of and at a given rate of interest. The CD therefore recognizes the obligation of the issuer to pay the principal (face value of the CD) plus interest to CD holder at maturity.

Originally, CDs were all issued on security paper and were high value bearer instruments that had to be collected by messenger from the issuer. However, it is now usual to issue CDs in electronic (book entry) from, and to use an international clearing system (e.g., Euroclear) to arrange the electronic book transfer and custody of the securities.

In London, there has also been the development o the CMO (Central Money Markets Office) at the Bank of England which safe keeps arranging electronic records of ownership. Eventually, this may lead to the virtual elimination of the paper CD.

In London, there has also been the development of the CMO (Central Money Markets Office) at the Bank of England which safekeeps CDs whilst arranging electronic records of ownership. Eventually, this may lead to the virtual elimination of the paper CD.
<h3><strong>CDs and Time Deposits Compared</strong></h3>
It is useful to compare a CD with an ordinary time deposit. With a time deposit, the depositor places a sum of money with a bank for a fixed time period. At maturity, the depositor can withdraw the money deposited plus interest.

A CD is a certificate for a time deposit: it is a bearer security, and the CD holder can sell the entitlement to someone else. The great advantage of a CD over a time deposit, to the CD holder is that it is a liquid negotiable instrument, tradeable in a secondary market. Hence, CDs provide a means for the holder to deposit funds short-term whilst retaining the flexibility to convert them into cash should the requirement arise.

In return for this liquidity, the CD holder must accept a lower yield than on a money market deposit. This is normally about 1/16<sup>th</sup> of 1% (6.25 basis points) or 1/8<sup>th</sup> of 1% (12. basis points) below the equivalent rate for a large deposit with the same bank.
<h3><strong>CD Markets</strong></h3>
Certificates of Deposit are issued in many centers around the world but the prime international centre is in London. The bank of England authorizes major banks to issue CDs in a variety of currencies, US dollars, yen, Australian dollars, Canadian dollars and ECUs. Certificates may be issued in other currencies too, provided the appropriate central bank is aware and des not object.

(Sterling CDs may also be issued by UK societies. However, the majority of CDs, whether issued by banks or building societies, are issued as part of normal money market funding arrangements).
<h3><strong>CD Maturities</strong></h3>
Whilst most CDs issued are for a period of one, three or six months, some may be issued on request for broken periods (colloquially known as cock dates). Also, some CDs are issued as part of a formal programme under which one dealer or group of dealers undertakes to buy a large volume (and value) of CDs for onward sale. Often these CDs will be for periods in excess of one year, perhaps as long as 3 or 5 ears.

The Bank of England does not consider that an instrument issued for longer than 5 years is, at any time during its life, a CD. The maximum term for which London Certificate of Deposit are issued is therefore five years. CDs with an original life of greater than one year will pay interest at least annually. (There is no minimum maturity for a CD).

Certificates of Deposit (CDs)

CDs are issued as interest bearing instruments. For example suppose that South Bank, a natural borrower of six-month Australian dollars is contacted by a money broker, who says that a lender is willing to lend six month Australian dollars at 61/16 % or alternatively will buy paper at 6%.
<h3>Primary Issue</h3>
South Bank agrees to issue a CD, and a deal is agreed for 20 milion Australian dollars (4 x AUD 5 Million). The lender/investor pays South Bank AUD 20 million (5 million for each CD).

Suppose there are 183 days in the six-month period. Each individual CD will promise to pay the presenter (bearer) at maturity the face value of the CD, AUD 5 million, plus interest of AUD 150,410.96 (day base= 365 days).

Note

Interest at 6% is calculated for each CD or AUD 5 million, as

AUD 5 million x (6/100) x (183/365)
<h3><strong>Secondary Market Pricing</strong></h3>
Let’s now suppose that buyer of the paper is Omega Bank, and that three months after the purchase, Omega Bank wants to sell two of the CDs.

Through a broker, a buyer has been identified who would be willing to buy the paper to yield 5% over the remaining term to maturity of 91 days.

Each CD has a defined value at maturity of AUD 5,150,410.96. A method has to be established for pricing such instruments (i.e., with a fixed terminal value) in the secondary market.
<h4><strong>Method 1</strong></h4>
An appropriate formula to use is the formula used for discount securities:

V = F/(1+(D/B*Y/100))

Where:

V is the secondary market price of the CD

F is the amount payable to the CD holder at maturity, i.e., principal plus accrued interest

D is the number of days to maturity

Y is the investment yield for the CD holder

B is the day base

In our example the CD buyer requires a yield of 5%.Each CD will therefore be sold at a price of:

AUD 5,150,410.96/ [1 + (91/365 x 5/100 )]

= AUD 5086997.70
<h4><strong>Method 2</strong></h4>
Another formula given in the formula sheet for your examination is a formula for calculating the proceeds of secondary market CDs.

Proceeds = FV   x  [(Coupon x Original life) + (B x 100)] / [(YTM x Days remaining) + (B x 100)]

Where:

FV  = face value of the CD

Coupon = interest rate payable on the original deposit (7.5% =7.5 etc)

YTM = Yield to Maturity, i.e., the interest rate yield required by the buyer in the secondary market (8.5%= 8.5 etc)

B= day base

In this example:

Proceeds = AUD 5 million x [(6 x 183)  + (365 x 100)] / [(5 x 91) + (365 x 100)]

=AUD 5 Million x (37,598/36955)

= AUD 5086997.70

The sale price of a CD can be higher or lower than its original purchase price, depending on how interest rates have changed between the purchase and resale date.

As a general rule however the resale price should usually be higher than the original purchase price. Given stable interest rates the value of a CD should rise gradually up to maturity. However if there is an increase in interest rates the value of a CD can fall.

In summary you should note that for primary CDs (new issue) the methodology for calculating interest is the same as for straightforward interbank deposits. The pricing methodology for secondary CDs is either the ‘discount to yield’ formula or the formula for calculating the proceeds of a secondary market CD.
<h3>Practice Problem</h3>
Attempt your own solution to this problem before checking the answer below.

A USD is issued at 5% in USD 1000000, 4/3/96 -29/11/96.On 2,June 1996, you buy the CD at 71/4%.
<h4><strong>Required</strong></h4>
a)     What is the purchase price you have to pay?

b)     If you were the seller of the CD what was your yield for the period in which you held the CD?

Issue Price and Secondary Market Prices of CDs

In addition to issuing long term bonds, governments issue short-term Treasury bills (T bills) of up to one year maturity. These do not carry a coupon, but are sold on a discount basis.

For example, the US Treasury, UK government and the French government are all active and regular issuers of bills. These represent the highest quality money market instruments available from a credit standpoint, and are used by researchers to measure short term risk-free rates.

In the UK, T bills are issued by the Bank of England on behalf of the government, normally on a weekly basis and normally by tender. Treasury bills can be issued for any term up to one year but the tendency has been to issue for 3 or 6 month periods. At the tender the prospective purchaser has to indicate the price he is prepared to pay. This price is a function of the interest rate expected.

<strong>Issue Price: Discount yield and True Yield</strong>

For example, if a bid of GBP 975,342.47 is tendered for a 90-day UK Treasury bill of one million pounds, it is because the bidder wishes to receive 7% discount. The amount of the discount bid is:

GBP 1,000,000 X 7% X 90/365   = GBP 17,260.27

The tendered price is therefore:         GBP 982,739.73

The add-on yield equivalent is:

GBP 17,260.27/GBP 982,739.73 X 365/90 = 7.12%

<strong>Secondary Market Trading</strong>

In the secondary markets, Treasury bills trade on a straight discount basis. The rates quoted on brokers screens are discount rates. They are therefore not comparable to commercial paper rates, which are add-on yields, unless converted.

The issuance of T-bills affects the money supply by temporarily soaking up liquidity. Buyers pay cash in exchange for promises to pay, and so cash is drained from the monetary system. Conversely, bills can be bought back to inject funds into the system. Selling unexpectedly large amounts of T bills tends to nudge interest rates upwards, since the average rate of accepted bids rises. Selling fewer bills than expected tends to nudge interest rates downwards. The central banks also stand ready to buy up T bills from traders or banks in need of temporary liquidity (such as when there is a ‘run on the bank’).

All the major bill markets have primary traders who are given special information and dealing privileges in return for obligations to buy certain percentages of the new issues. There is always a good liquid market in Treasury bills.

Traders aim to buy at a high rate of discount and sell at a lower rate of discount. A trder who buys USD 1,000,000 of 70 day US T bills at 5.625% on the same day has traded at the following prices:

Purchase – USD 988,819.44

Sale        + USD 989,062.50

<strong>Profit      + USD 243.06</strong>

<strong>Rider:</strong>
<ol>
	<li>You      buy 90-day treasuries with a yield of 4.24%.The face amount is USD 10      million. What would you pay for them?</li>
</ol>
<ol>
	<li>You sell      on the treasuries 21 days later at 4.15%.What would you receive for them?</li>
</ol>
<strong>Solution:</strong>

Discuss the solution in the forum

<strong>
</strong>

Introduction to Treasury Bills

A banker’s acceptance is a bill of exchange drawn to finance trade (exports and imports) and accepted by a bank as good for payment. Originally, such bills were all transaction specific. In other words, a specific cargo would be financed, typically by the exporter drawing a bill on the importer, and then offered to a bank to accept. The bank would place its stamp and authorized signatures on the bill and from then on it became, for all intents and purposes, paper with the risk and quality of the accepting bank.

The accepting bank may pass on its accepted bill to another bank which if it were of better quality than the original bank may also accept it-thus increasing the quality of the paper itself. The quality of the accepter of the paper is the guide to the rate of interest that the bill is likely to attract. The better the quality, the finer the rate.

A banker’s acceptance is drawn from a specific amount (originally the value of the cargo) and does not bear an interest coupon. Instead it is discounted. The methodology for such a discount is ‘straight discount’, normally, although some bills go through at ‘discount to yield’.

The best quality bills in the UK are eligible for re-discount at the Bank of England. Although bills may not necessarily be drawn to cover specific cargoes there usually has to be an underlying trade business that the Bank of England can recognize. However, in the United States BAs can be drawn for more flexible reasons such as the funding of stocks or work in progress.

<strong>Example</strong>

A bill f exchange has been drawn for GBP 1 million, payable on 14 September. N June 20 (86 days to maturity), the bill is presented to Sahara Bank, which discounts it a 8% and pays away GBP 981,150.68. This bill is ‘ineligible’, since Sahara bank is not a recognised market marker in BAs.

On June 22, Sahara Bank passes the bill to a UK discount house, which accepts the bill and discounts it at 7.25%. It pays away GBP 983315.07 to Sahara bank. The discount house’s acceptance of the bill gives it eligibility and the bill can now be traded at much finer rates.

On June 23, the discount house sells the acceptance to an investment bank at 7.125%. The discount house receives GBP 983,797.95.

The investing bank does not accept the bill, but simply buys it with the intention of holding t until maturity.

At maturity on September 14, the investing bank receives GBP 1 million on presentation of the bill.(In the event that the bill is not paid direct by the original ‘drawee’ the presenter would expect the discount to pay, and the discount house in turn would look to Sahara Bank to honour its acceptance.)

Introduction to Bankers' Acceptance

Commercial Paper (CP) is a short-term financial instrument, consisting of unsecured promissory notes issued in bearer form which can be therefore be readily traded. At maturity, the CP issuer pays the amount due to the person presenting the paper.

Commercial paper is an example of ‘securitization’ i.e raising loan funds by issuing negotiable debt securities rather than by bank borrowing. A bank acts as agent for a CP issue, packaging and selling the paper to investors, but does not advance its own funds. (Securitsation, such as CP is also a form of disintermediation, i.e raising funds directly from investors without the banks acting as intermediaries through their loans and deposit business.)

CP is issued as a series of notes, and each note promises to pay the bearer a stated sum of money at the maturity date. Each note shows:
<ul>
	<li>The      name of the issuer</li>
	<li>The      amount (value) of the note</li>
	<li>The      issue date</li>
	<li>The      maturity date</li>
	<li>A      certificate of authentication, signed by an authorized signatory of the      issuer’s issue agent</li>
</ul>
Each note will also indicate that the note is negotiable, its bearer is entitled to payment, and the payment will be made (on presentation of the note at maturity through a recognised bank) by the issue agent on behalf of the company. An issuing or paying agent handles the administrative processes.

An investment bank will help arrange the issuance of CP by its large corporate clients, and provide them an immediate market by undertaking to bid for the paper and on-trade it to the investor market .A CP trader at a bank hopes to make a small margin of profit on huge volume turnover. This margin might be small as 2 basis points, i.e USD 50 on a USD 1m CP issued for 90 days. The investor in CP is buying the unsecured debt of the corporate issuer, but in buying through a bank dealer the investor is also getting a moral obligation from the bank dealer to buy it back again, at the prevailing market price, if the investor wishes to return to cash. This obligation is not enforceable.

<strong>Origins of the CP market</strong>

Like CDs, commercial paper (CP) originated in the US market and its creation and volume growth is very much a product of the banking environment there. The Us banking industry is still very fragmented, (despite some mergers and takeovers). About 10 or 15 years ago it was even more so, with a large number of local banks. In such an environment, it was often the case that major trading and manufacturing companies were a better credit risk than the banks. These institutions needed a channel through which money could be directed from cash-rich companies that needed short term financing. The invention of commercial paper provided such a channel avoiding the need of banks to intermediate through the loans and deposits market.

The elimination of banks as intermediaries creates cost benefits which are shared between:
<ul>
	<li>The      borrowers, who achieves cheaper funding than from bank lending, and</li>
	<li>The      investor, who achieves an improved yield, at low risk, compared with bank      deposits</li>
</ul>
<strong>Maturing of CP</strong>

In the US CP market, commercial paper is limited to a 270 days tenor, with 14 days being the most common maturity. CP is negotiable and is in bearer form. Settlement takes place on the same day. All issues must carry a credit rating .Only US dollar issues are possible. The benchmark cost of funds is the Federal Reserve Composite rate.

In the Euromarkets and in the domestic sterling market, CP can have a tenor of up to one year (364 days), but the average life at issue is about 60 days. Issues are made in the following main currencies. USD, GBP, DEM, JPY and CHF. However about 80% of issues are denominated in US dollars.

<strong>CP Yields</strong>

Rates on US Commercial paper, like those on bills and Bas are quoted on a discount basis. (However, a small amount is issued in interest-bearing form.) In the markets outside the US, CP is issued on a discount to yield basis, meaning that the face value of  the paper which will be payable at maturity is discounted back to the date of issue at a rate of yield rather than at a straight discount.

Some small amounts of CP in the Euromarkets are issued with a rate of interest and therefore can be treated mathematically in the same way as a CD.

<strong>Credit Ratings</strong>

Investors do not have the time or resources to investigate credit, so the use of credit ratings is essential to the working of the CP market. The majority of the paper is rated by two agencies, Standard and Poors and Moodys.

A rating of A1/P1 might be necessary to persuade investors to buy the paper.

Introduction to Commercial Paper (CP)

Money Markets

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Money Markets

Lessons

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