How negotiable certificates of deposit are traded in the money market
By Sunil K. Parameswaran
Debt securities can be negotiable or non-negotiable. Many of us trade stocks. Suppose two weeks ago you bought L&T shares from an unknown party in Ahmedabad, and today you sold them to an unknown party in Hyderabad. These transfers are possible because the shares are negotiable securities, which can be freely traded in the market.
Principal and interest
However, debt can be negotiable or non-negotiable. Government bonds and corporate bonds can be bought and sold. The fact that many of these securities are illiquid is another issue and as a result we may have difficulty buying or selling. However, take a National Savings Certificate or NSC. At maturity, the original buyer will get his principal back with interest. However, if he needs the funds before that, he can pledge the certificate and borrow, but cannot sell it to someone else. Likewise, fixed bank deposits cannot be transferred by the depositor to another party.
Negotiable certificates of deposit or NCDs are nothing more than FD receipts that can be traded in the market. What we call a fixed deposit in India, is known as a term deposit or TD, in the United States. Normal TD certificates are not negotiable, as is the case in India. However, negotiable CDs are securities negotiable in the money market. They are not intended for little boys, as the minimum ticket size is US $ 1 million in America. There are brokers who create a market for these securities, by quoting bid and ask prices. Buyers and sellers can negotiate with a reseller of their choice.
The interest rate paid by the issuing bank is called the coupon rate. At maturity, the issuer will pay the coupon based on the original term to maturity of the instrument, which is nothing more than the term to maturity at the time of maturity. program. For example, consider a NTM whose principal is $ 1 million; a coupon of 4.2% per year; and an initial term to maturity of 162 days.
Suppose the day count convention is Actual / 360, that is, the year is assumed to be made up of 360 days, which means that each month is assumed to be made up of 30 days. At maturity, the last holder will receive 1,000,000 x[1+ 0.042 x(162÷360)] = 1,018,900. In the US and EU, the convention for counting days is Actual / 360. In UK and India, it is Actual / 365.
The price of this CRS can be determined before maturity by discounting the final gain by the prevailing market yield. Discounting is done using the actual or remaining time to maturity. As is the norm in money markets, discounting is done on the basis of simple interest. Suppose the yield at any given time is 4.5% per annum and the actual term to maturity is 108 days.
The dirty price of the NCD is given by 1.018.900 ÷ [1+0.045x(108÷360)] = 1,005,328. The accrued interest is 1,000,000 x 0.042 x (162-108) ÷ 360 = 6,300. Thus, the own price of NTMs is 1,005,328 – 6,300 = 999,028. The actual price payable by a buyer is the dirty price and not the clean price.
Forward NTMs are also available, which may be several years before maturity. These will generally pay interest on a semi-annual basis. This will be the center of attention for a later article.
The author is CEO, Tarheel Consultancy Services