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An economic analysis of bank-issued market-indexed certificate of deposit – an option pricing approach

Author

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  • Rodrigo Hernández
  • Jorge Brusa
  • Daniel Pu Liu

Abstract

In this paper, we develop valuation models for market-indexed certificate of deposits (market-indexed CD) based on option pricing model. We show that the payoff of an uncapped market-indexed CD can be duplicated by the combination of a zero coupon bond and a call option on the index. Furthermore, we find that the profit of issuing a non-callable market-indexed CD is negative and it is equivalent to the value of a put option on the underlying index with an exercise price equal to the initial index value. Based on the findings in the paper, we conclude that in order to make a profit, a market-indexed CD must have at least one of the following features: a call provision, a guaranteed payoff lower than par value, a cap on the return, or a participation ratio less than 100%.

Suggested Citation

  • Rodrigo Hernández & Jorge Brusa & Daniel Pu Liu, 2011. "An economic analysis of bank-issued market-indexed certificate of deposit – an option pricing approach," International Journal of Financial Markets and Derivatives, Inderscience Enterprises Ltd, vol. 2(3), pages 195-208.
    • Handle: RePEc:ids:ijfmkd:v:2:y:2011:i:3:p:195-208
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