Wednesday, February 17, 2010

What is a Negotiable Certificate of deposit?

A certificate of deposit(cd) is a short-term investment whereby an investor will deposit a sum of money in a bank and at maturity the investor will obtain his money back with interest. The cd is issued at a discount to the face value and at the maturity date the investor will thus redeem the face value of the CD.  The investor cannot get his money back before the maturity date.

The negotiable certificate of deposit (NCD) however can be sold in the secondary market by the initial investor. He can thus get back his money before the maturity date. He will however have to accept a reduce interest. The negotiable certificate of deposit can thus be traded in the secondary market until it reaches maturity. At that point the last person that hold the NCD can redeem the face value of the NCD.

Since the NCD is issued by a bank then the return on it must be greater than on the treasury bill. This is because the treasury bill is a safe investment and has no default risk. The return on the NCD will thus be slightly greater than the return of the treasury bill to compensate the investor for the additional risk However since it is issued for a short period of time the solvency of the bank can be predicted. As a result the extra premium is quite small.  As a result the return on the NCD is quite small compared to other money market instrument. Furthermore the NCD is issued at high denomination as a result the retail investor cannot have access to NCDs. Average investor can only access them through a money market  mutual fund unless he has a lot of money to be able to buy individual NCD from banks or through his broker.

However despite these disadvantages there are two advantages that makes the NCD worth while investing in. First of all if you have some money in a bank account the return will mostly be small. Then investing in an NCD will give a slightly higher return than the average savings account. Furthermore if you cannot afford to lose your money but want to obtain higher return then the NCD is the way to go since the chance of the bank defaulting on the NCD is negligible.  

Bookmark and Share

No comments:

Post a Comment