Definition
A Certificate of Deposit (CD) is a negotiable financial instrument issued by a bank in return for a term deposit. Typically lasting up to five years, a CD offers competitive interest rates to attract larger investors. Originating in the USA in the 1960s, sterling CDs were introduced by UK banks in 1968 to draw funds away from clearing banks and attract them to merchant banks.
Examples
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Short-term CD: An individual invests £20,000 in a 6-month CD yielding an annual interest rate of 1.5%. After six months, the interest earned would be £150.
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Long-term CD: A corporate entity places £50,000 in a 5-year CD with an annual interest rate of 3%. Over five years, the total interest accumulated would be £7,500.
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Subdivided CD: An investor holds a £50,000 CD but negotiates to sell part holdings of £10,000 each in the secondary market.
Frequently Asked Questions (FAQ)
Q: What is the primary advantage of a CD?
A: CDs offer higher interest rates compared to regular savings accounts, making them an attractive option for risk-averse investors seeking stable returns.
Q: Can the money in a CD be accessed before maturity?
A: Early withdrawal from a CD typically incurs a penalty which might include a forfeiture of a portion of the accrued interest.
Q: Is the interest earned on a CD taxable?
A: Yes, the interest earned from CDs is subject to federal, state, and local taxes depending on the jurisdiction.
Q: Can CDs be sold before maturity?
A: Yes, CDs can be sold in a secondary market. The sale price depends on prevailing interest rates and demand for such securities.
Q: What differentiates a CD from a savings bond?
A: While both are low-risk investments, CDs offer fixed interest rates and specified terms, whereas savings bonds may offer variable rates and longer holding periods.
- Merchant Bank: A financial institution engaged in investment activities, including issuing and trading CDs.
- Clearing Bank: A bank that processes checks and money transfers between different banks.
- Secondary Market: A market where investors buy and sell securities like CDs after the original issue.
- Discount House: A financial institution specializing in dealing short-term government and high-quality corporate debt securities.
Online References
Suggested Books for Further Studies
- The Banking System by Marie T. Romain
- Money Market and Capital Market by Gleitzman & Gerson
- Understanding Financial Statements by Aileen M. Ormiston
Accounting Basics: “Certificate of Deposit” Fundamentals Quiz
### What is a Certificate of Deposit (CD)?
- [ ] A form of credit card issued by banks.
- [ ] A government-issued bond.
- [x] A negotiable certificate issued by a bank.
- [ ] A personal loan agreement.
> **Explanation:** A Certificate of Deposit (CD) is a negotiable certificate issued by a bank in return for a term deposit.
### When did sterling CDs make their debut in the UK?
- [ ] 1965
- [ ] 1958
- [x] 1968
- [ ] 1970
> **Explanation:** Sterling CDs were introduced by UK banks in 1968 to attract funds from larger investors.
### Are CDs primarily aimed at individual small investors or larger investors?
- [ ] Small individual investors
- [x] Larger investors
- [ ] Corporate trustees
- [ ] Municipal bondholders
> **Explanation:** CDs are aimed at attracting larger investors with competitive interest rates and negotiable terms.
### What characterizes the secondary market for CDs?
- [ ] It does not exist.
- [x] It facilitates the buying and selling of CDs before maturity.
- [ ] It is regulated by SEC only.
- [ ] It offers CD insurance policies.
> **Explanation:** The secondary market for CDs allows for buying and selling of CDs before their maturity date.
### What happens if a CD is withdrawn before its maturity?
- [ ] It increases in value.
- [ ] The interest rate rises.
- [x] Penalties and forfeited interest might be incurred.
- [ ] The contract is automatically renewed.
> **Explanation:** Early withdrawal from a CD usually involves penalties, including forfeiture of accrued interest.
### Which sector initiated the issuing of CDs to attract funds away from clearing banks?
- [ ] Central Banks
- [ ] Credit Unions
- [x] Merchant Banks
- [ ] Investment Trusts
> **Explanation:** Merchant banks initiated the issuing of CDs to draw funds away from clearing banks with competitive interest rates.
### Can CDs be issued for amounts smaller than £10,000?
- [ ] Yes, always.
- [ ] Only during financial crises.
- [ ] If approved by a central bank.
- [x] No, generally issued between £10,000 and £50,000.
> **Explanation:** CDs are usually issued in amounts between £10,000 and £50,000 though they can be subdivided for smaller transactions in the secondary market.
### What commonly affects the interest rate on a CD?
- [x] Duration of the term deposit
- [ ] Type of currency
- [ ] Size of issuing bank
- [ ] Fidelity of depositors
> **Explanation:** The interest rate on a CD is predominantly affected by the duration of the term deposit—the longer the term, the higher the interest rate typically.
### What do investors gain by purchasing a CD from the secondary market?
- [ ] Free compounding interest.
- [ ] Additional dividends.
- [ ] Equity in the issuing bank.
- [x] Liquidity before CD maturity.
> **Explanation:** Purchasing a CD from the secondary market offers liquidity since it allows investors to buy CDs that others wish to sell before maturity.
### What feature distinguishes a CD from regular savings accounts?
- [ ] Easier withdrawal terms
- [ ] Variable interest rates
- [ ] Fees associated with managing the account
- [x] Fixed interest rates over a specific term
> **Explanation:** CDs offer fixed interest rates over a specific period, whereas savings accounts usually provide variable interest rates and easier access to funds.
Thank you for exploring the intricate details of Certificates of Deposit. Your rigorous effort in mastering these essential financial instruments reflects a commendable pursuit of financial excellence!
