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

Authors: Rodrigo Hernández; Jorge Brusa; Daniel Pu Liu

Addresses: College of Business and Economics, Radford University, Radford, VA 24142, USA. ' Sanchez School of Business, Texas A&M International University, Laredo, Texas, 78041, USA. ' Sam M. Walton College of Business, University of Arkansas, Fayetteville, AR 72701, USA

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%.

Keywords: market indexed certificates of deposit; MICD; structured products; option pricing; financial innovation; valuation modelling; zero coupon bonds; call options.

DOI: 10.1504/IJFMD.2011.042600

International Journal of Financial Markets and Derivatives, 2011 Vol.2 No.3, pp.195 - 208

Published online: 18 Sep 2011 *

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