Compare certificate of deposit

Abstract

Deregulation and competition have led to the introduction of many new esoteric investment products in the financial service industry. One such product is the enhanced certificate of deposit, which contains embedded interest rate options. These securities are commonly known as flex certificates of deposit. We find that these products are currently being priced in a peculiar manner. A discussion of the logical breakdown of options embedded in the flex certificate of deposit is given. We also consider why banks are willing to give away valuable interest rate options. ?? 2004 Academy of Financial Services. All rights reserved.

Jel classification: G2

Keywords:Certificates of deposit; Flex CDs; Flexible CDs; Enhanced CDs; Embedded options

1. Introduction

The purpose of this article is to provide a general framework for understanding enhanced certificates of deposits (CDs) that contain embedded options and a mechanism for comparing enhanced CDs, which contain these embedded options, with traditional CDs, which contain no options. This approach will be useful to both banks and depositors. It enables bankers to better price the products they offer and allows them to understand the risks associated with these products. This approach aids depositors in comparing different CD products offered by these institutions. The research here suggests that the current yields on CDs containing these embedded options do not accurately reflect the value of the investor's options.

Retail banking has undergone dramatic changes in recent years. Due to deregulation and increased competition, banks must aggressively compete to maintain market share and profits. This competition among banks has led to the introduction of many new deposit instruments. In an effort to increase deposits as well as lower the cost of funds, new exotic products are being offered today.

Enhanced CDs are now being offered with features such as penalty-free withdrawals, unlimited deposits, and the ability to adjust the "fixed" interest rate to a higher rate at any time during the life of the CD. There are variable rate CDs offered with floors, CDs with payouts tied to stock indexes, and even CDs whose payout depends on the winners of sporting events. One specific example of an enhanced CD is the flex CD offered by a regional bank located in the southeast, which will be referred to as Bank A1 throughout this paper. The flex CD is offered with 13- and 21-month maturities and contains the following three options: the option to make deposits up to $99,000, one penalty-free withdrawal of any amount, and a one-time rate adjustment option. A survey of banks located in the Birmingham Alabama area, shown in Table 1, revealed that other banks in that area offer products similar to the flex CD of Bank A. Outside the Birmingham area, other banking institutions (referred to as Banks 1, 2, 3, and 4) are also offering similar products. Bank 1 offers a 24-month flex CD that permits additional deposits to be made to the certificate in an amount equal to the original deposit, one penalty-free withdrawal, and one rate adjustment option. Bank 2 offers a 12-and 24-month "Triple Option" CD that allows deposits up to the original face value of the CD, one penalty-free withdrawal, and a one-time rate adjustment option. Bank 3 offers a 7- and 12-month "Flex Plus Certificate" with two embedded options: unlimited deposits and one penalty-free withdrawal. Bank 4 offers its "Flex Savers" CD with both 24- and 36-month maturities that allow the depositor to make deposits up to 25% of the original deposit amount, withdrawals of 25% of the original deposit amount, and a one-time rate adjustment option.

Previous research has been devoted to embedded demand deposit options. Hannan and Berger (1991) found that four factors influence an investor's early withdrawal decision: the reinvestment incentive, the size of the face value of the deposit, whether or not the CD is pledged collateral, and idiosyncratic liquidity needs of the investor. Gilkeson, Porter, and Smith (2000) developed the withdrawal option pricing hypothesis, which suggests yield spreads between 5-year retail CDs with a par value greater than $90,000 and similar treasuries reflect embedded withdrawal options. Brooks (1996) provided a framework for comparing CD products containing embedded derivatives by demonstrating how to compute the annual percentage yield (APY) and effective annual rate (EAR) for CDs with embedded withdrawal options.

Certificates of deposit provide banking institutions with a significant source of funds. While demand for deposit products has significantly declined since the 1980s, evidence suggests that deposit products are becoming increasingly popular with individual investors. The FDIC's second Quarter 2002 Quarterly Banking Profile (FDIC, 2002) reported that, among FDIC-insured institutions, deposits were up 4.6% from second quarter 2001 to second quarter 2002. In addition, the Profile reported a 14.1% increase from second quarter 1999 to second quarter 2001 (FDIC, 2001). A survey conducted in the southeastern United States revealed that CDs represented an average of 45% of the total assets of small banks. Thus, in order to remain competitive, banks need methods to aid them in setting rates and providing insight into the potential risks associated with these deposit products. For example, in the case of the flex CD, banks need to understand the likelihood and related costs of depositors exercising any of the embedded options. Likewise, individual investors need these same methods to compare the wide range of products offered by banks. Knowledge of the potential value of these exotic products will enhance investor decision-making.

In this article, we provide a framework for understanding the options embedded in the flex CDs offered by Bank A. Through this procedure, it will be shown that these products are priced in a very unusual manner. We begin with a general discussion of the bank production function and a brief comparison of the terms of the flex CD. Next, we present a logical breakdown of the embedded options in the product and the implications they have on pricing the flex CD. In this discussion an explanation will be offered explaining why banks may price the products in the current manner. Finally, we will conclude the paper with a discussion focusing on the implications and opportunities this pricing procedure provides to the individual investor.

2. The bank production function

Studies involving the production approach began with the works of Benston (1965) and Bell and Murphy (1968) which explain banking activities as the production of services to depositors and borrowers. By facilitating the flow of funds from surplus units to deficit units, banking institutions provide a crucial function in financial markets. In facilitating this flow of funds, banks invest in loans and securities using the funds obtained from deposit accounts and borrowed funds. Profits are generated by repackaging these funds into various products attractive to lenders and retail investors, thus generating a spread between the average cost of funds and the return earned on the bank's loan portfolio. This task is associated with interest rate risk, liquidity risk, market risk, and credit risk. Therefore, banks must set rates on deposits and loans while considering these risks and other costs associated with running a bank. Another consideration that must be made, particularly when determining the rate to be offered on the flex CD, is the retail customer's cost of convenience. Convenience can play a major role in the inefficient exercise of the embedded options. For example, it might be the case that a bank can knowingly offer an above average rate on a flex CD if they are reasonably confident that a large percentage of their customers will not exercise the embedded options due to inconvenience. Inconveniences could include such factors as time and effort of keeping up with current market rates and the physical effort required to go to the bank and exercise the options.

Much research has been devoted to the pricing of CDs, with most of the attention being placed on large-denomination CDs (James, 1987; Hannan & Hanweck, 1988; Ewing, Payne, & Forbes, 1998). A second group of studies has focused on small/retail CDs (Berger & Hannan, 1989; Calem & Carlino, 1991; Cooperman, Lee, & Lesage, 1991). Hempel and Simonson (1999) examined the funding characteristics of commercial banks and discovered that bank size played a role in the pricing of time deposits. Jordan (2000) studied failing banks in the New England area and found that banks facing a shortfall in funding were typically more aggressive in their pricing. Gup and Nam (2003) examine variations in CD yields and find strong evidence that asset size, the cost of funding earning assets, and the ratio of noninterest-bearing deposits to total deposits were significantly related to these pricing differences.