Valuation of Certificate of Deposit (CD) With Transfer Option
This chapter demonstrates through a practical example how to apply what we have learned so far to the pricing of a seemingly complicated financial asset. A certificate of deposit (CD) is one of the simplest investment tools offered by banks. The bank issues a certificate stating the amount of cash it receives, the length of time to maturity and the prefixed interest rate it agrees to pay to the owner of the certificate. Recently, many banks in Japan introduced a new type CD’s which comes with the option of closing or selling it back to the bank before maturity. This option given to the CD holder is a type of prepayment risk for a bank. For example, a CD with a 10 year maturity can now be closed at any time before the maturity date, but in return it receives only a penalized interest rate. In this chapter, we discuss how to use a no-arbitrage pricing argument to determine a theoretical value for the penalized interest rate.
KeywordsInterest Rate Asset Price Financial Asset Expected Loss Exchange Option
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