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.  

What are eurodollars?

The term eurodollar very often tend to confuse investors into believing that the instrument is related to the dollar or the euro. The eurodollar is a deposit, cd or NCD  that a united states bank will have with a bank outside of the united state. Hence if a European bank has a deposit, cd or NCD at a bank in Australia then it will be called a Euroeuro. And finally if a Japanese bank will have a deposit , cd or NCD with a bank in France it will be called a euroyen

The advantage of eurodollars is that because they are less liquid then normal NCDs the return on them is greater. The eurodollar however is only to large institutions so your best et to have exposure to them is through

What is a capital market?

The capital market is a market where securities that  that has a long-term maturity are traded. These include treasury notes, treasury bonds, normal and preferential stocks. Generally securities with a maturity of greater than 1 years are traded in it. As you can see all securities that are not traded in the money market are traded in the capital market. The name capital market also indicate that companies and government raise  capital in this market.

The capital market is divided into two different markets. Firstly the stock market also known as the equity market where normal and preferential stocks are traded. Secondly the bond  market also known as the debt market where notes and bonds are traded.

Hence we can see that when companies and government need short term financing they raise funds in the money market whereas if they want to raise fund over the long term they would do so in the capital market.

What is a repo/reverse repo?

A repo is a repurchase transaction and it is a security that is part of the money market.

So what is a repurchase transaction? A repurchase transaction is similar to a transaction that takes place in a pawn shop. The owner of a property goes to a pawn shop and exchange it for cash but he promises to come back later to buy the property at a higher price.

Now the same goes for a repo.

1. An institution that needs cash over a short period of time goes to lender with government securities such as government bonds, treasury bills or any other financial instruments that have a high rating as collateral.

2. The lender will lend money to the borrower in exchange for the collateral. The borrower also agrees to buy back the security at a higher price at a particular time.  The difference between the two price is the profit of the lender. The time of repurchase can be from one day to a few months.If the repo transaction is greater than a month it is called a term repo. Less than a month it will be a simple repo.

3. At the agreed time the borrower buy back the collateral at the agreed higher price.

4. In case of default of the borrower the lender keep the collateral.   

You can also have what is called a reverse repo. This is the opposite of a repo. In a reverse repo the the institution will buy a security and later agree to sell the security to the seller at a higher price.

Technically the two terms are used in different circumstances but put simply if the transactions is viewed from the borrower’s perspective where the borrower will repurchase the security later it is a repo but from the lender’s perspective the lender is forced to sell the security to the borrower then it is a reverse repo.

A typical case is when banks obtain funds from the central bank. the bank is considered to be doing a repo while the central bank is considered to be doing a reverse repo.

However it is mostly large institutions that deal in repos.

What is a commercial paper?

The commercial paper is a form of debt securities that is issued by companies. As we have seen in this post on bonds government and corporations issue bonds that have maturities of greater than one year on the capital market. With regards to maturities shorter than one year the government will issue treasury bills whereas corporations will issue commercial papers. The commercial paper will thus be, like the treasury bill, a money market instrument.

Hence the commercial paper will be issued at a discount by companies and at maturity the holder of the commercial paper will be paid the face value of the commercial paper. The discount rate will depend on the credit rating of the company and present market conditions. Since it is only companies with good credit rating that can issue commercial papers, the discount rate will slightly higher than government for treasury bills.

Companies are constantly in need of funds to settle current liabilities and to buy inventories. This is because there is always a mismatch between income and spending, The companies will thus raise the short term fund needed in the money market because use of banks for such short-term financing is costlier and time consuming.

Just like the treasury bills, commercial papers are quite safe. This is because the short-term maturities at which they are issued means that investors can determine whether the firm has a risk of default on the commercial paper. This is because investors would have known from previous financial statements whether the companies is sound and what is the possibility of it going bankrupt. However as you may know banks with their exposure to risky derivatives or bank runs may go bankrupt even if they were sound a few months or weeks before.However given the slight possibility of going bankrupt the return will be slightly higher than on treasury bills.

You might thus think that commercial papers will be good to invest in. However these commercial papers are issued at high denominations. As a result the retail investors like you cannot invest directly in them. Thus the only way to get exposure to them is through money market mutual funds.But like I have said in a previous post it would be better if you invest in stocks, government and corporate bonds and other higher yielding instruments.

Happy investing.