Saturday, 6 October 2012

Certificates of Deposit : market price = fair value

If the simple CD is tradeable, when what is its price?  Well, that's two questions:  what is its fair price at any moment during its life, and second, what is its market price.  Well, remember, it is a two step process - first you get the future value of that single cash flow you'll get on expiry (par plus whatever interest you earned) for some given principal amount $P$.  There's nothing really in that which could vary over time.  The value at expiry is the same regardless of how close to expiry you are.

What might change is the yield you'd use to discount this singular known future value.  Why? Well, imagine you bought a 1 year CD for principal $P$ and a nominal yield $y$, which was the going rate when you entered the market.  The market being that set of institutions from that country who are also offering 1 year CDs on principals the size of $P$.  Now where does this number come from?  Well, as you'd imagine, it is sensitive to short term interest rates.  So Imagine you just bought this new CD and got a rate of $y$ when that very moment the domestic central bank raised the short term policy rate by a whole percentage point.  Well, the CD market would adjust and offer the marginal next customer a higher rate of return $y^\prime$.  So when you come to present value the same fixed future value $P(1+y)$ you get $P \times \frac{1+y}{1+y^\prime}$ since the fraction is less than 1, which results in some amount less than $P$.  That is, the fair value of your security, this instrument which was going to give you $P(1+y)$ in a year, is now worth less than $P$.  Another way of saying this is that the value of the CD is sensitive to fluctuations in interest rates in the economy.  It has interest rate risk.  That new value, call it $P^\prime$, is the new fair value of the CD.

The only moving part here is $y^\prime$, the single prevailing rate you discount your future payment.  This, in a sense, is also the market price.  Now this is unlike more complex securities in a number of ways.  Often other securities have more moving parts, but you'll always just have a single market price.  But for now, enjoy the simplicity of the relationship.  Regardless of how the market actually quotes this rate, whether they tell you it as the current value $P^\prime$, whether it is quoted as $y^\prime$ itself, whether it is $100-y^\prime$ or any other transformation, the bottom line is, that market quote can be transformed into $y^\prime$.  Now imagine I had two CDs, each with different nominal yields $y_1$ and $y_2$, on identical principals $P$ and expiry 1 (year).   Clearly they'll be worth different amounts in any given prevailing market environment $y^\prime$ and time to expiry $t$.

Just for now, let's pretend the market quotes the market yield as the current cash value of an invested principal $P=1$.  That is, pretend the market price of a CD is expressed as $P^\prime = \frac{1+y}{1+y^\prime}$.  This market price is then synonymous with the fair value of the instrument, which is also $P^\prime$.  That identity relationship doesn't often happen with other financial instruments.  With other instruments, there's a gap between the market price and the fair value.

In the next post I'd like to introduce you to the second of the great risks in finance, already present in this simplified product. 

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