Why are derivatives used in market-inked CDs?
A market-linked CD, although a single account between depositor (final customer) and deposit-taking-institution (bank), consists of two differentiated financial instruments:
- A bank deposit which provides the safety of FDIC insurance and principal protection (if held to maturity).
- A derivative which provides the potential of an enhanced interest payment provided that a certain condition is met.
Since bank deposits are a much more common instrument than derivatives, we will devote this short post to the latter. Simply put, a derivative is a contract whose value is dependent or based on the result or performance of another instrument, commonly referred to as the "underlying".
It's typically most common in retail based products for derivative underlyings to be a financial security of some sort like an equity index (S&P500) or a basket of stocks (Coca-Cola, IBM, Verizon). However, a derivative underlying can also be something that's a bit more obscure such as a commodity (West Texas Crude Oil), weather performance (inches of rainfall during the year) or even a sports event (winner of the World Series).
A baseline fundamental in understanding a derivative transaction is that it allows a purchaser to acquire a right to sell or buy the underlying from a seller who has the obligation to sell or buy the underlying if a certain event occurs. In a derivative transaction there must always be a buyer and a seller. The buyer acquires the right (with no obligations) and the seller acquires the obligations (but no rights). Logically, the buyer must compensate the seller for their potential future obligations with an upfront cash disbursement, commonly called a "premium".
Due to this decoupling of rights and obligations dependent on a given result or performance, the option premium paid by the buyer represents only a small portion of the price of purchasing the full value of the actual underlying. In other words, a derivative allows a buyer to receive a highly leveraged exposure to the underlying (no need to disburse the total price of the underlying to get a certain proportion of the upside).
Most derivatives are "cash settled" by the difference between the price at which a buyer has the right to buy and the price at which the seller has the obligation to sell. Therefore, if the buyer has a right to purchase an underlying at a price of $1000 and the seller has the obligation to sell that same underlying at a current price of $3500, the amount settled to the buyer will be $2500.
A simple example of a derivative is an agreement that gives a purchaser the right to receive the upside performance of the S&P 500 index during a certain time period but no obligation to absorb the losses. The seller of the option will demand an upfront premium from the buyer to commit to their potential future obligation. This premium is only a small portion of the actual price which would be necessary to purchase full exposure of the underlying S&P 500 index. If the price of the S&P 500 increases during the course of the derivative contract, the seller will be obliged to make a payment to the buyer equal to the increase of the index.
Through a market-linked CD account, an issuer can combine the deposit with a leveraged derivative. The result is that the depositor gets a very compelling proposition: FDIC insured principal protection with a higher upside potential than other deposit products can offer.
Derivatives are used in a variety of financial products and can range from being very simple to extremely complex. There is often a misunderstanding of if and how they are used in Market Linked CDs. It's our hope that this post sheds a little light on their purpose for this particular type of account.
Matthew Lifshotz, Director Business Development at Choice
Matthew started out professionally in the financial services sector (Merrill Lynch), gaining strong knowledge and insight into the demands and requirements of the wealth management and brokerage sector before moving to a business development role in the financial software industry (Smart Pros). Connect with Matthew here.