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• W283443384 abstract "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; 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. …" @default.
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• W283443384 date "2004-04-01" @default.
• W283443384 modified "2023-09-26" @default.
• W283443384 title "Embedded Options in Enhanced Certificates of Deposit" @default.
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