In class we discussed the Term Structure of Interest Rates, expressed graphicall
ID: 2805515 • Letter: I
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In class we discussed the Term Structure of Interest Rates, expressed graphically in what is known as the “Yield Curve”. Normally the X axis of the Yield Curve is the Term to Maturity of the bond, while the required return (Yield) is measured on the Y axis. Many economists believe that it is useful to distinguish two Segments along this curve, one for short-maturity instruments, called the Money Market, and one for longer term instruments, called the Capital Market. One important component of the Money Market is Commercial Certificates of Deposit (CDs), which are actually bank deposits sold in denominations of $100,000, and traded daily in an efficient market. In class, we observed that CDs currently pay extremely low interest rates approaching zero. Campbell attributes this low rate to a dramatic change on the balance sheets of commercial banks, and to a corresponding change on the balance sheet of the Federal Reserve (Fed) since 2008. What is the category on these balance sheets that Campbell believes explains very low interest rates on CDs? In class we discussed the Term Structure of Interest Rates, expressed graphically in what is known as the “Yield Curve”. Normally the X axis of the Yield Curve is the Term to Maturity of the bond, while the required return (Yield) is measured on the Y axis. Many economists believe that it is useful to distinguish two Segments along this curve, one for short-maturity instruments, called the Money Market, and one for longer term instruments, called the Capital Market. One important component of the Money Market is Commercial Certificates of Deposit (CDs), which are actually bank deposits sold in denominations of $100,000, and traded daily in an efficient market. In class, we observed that CDs currently pay extremely low interest rates approaching zero. Campbell attributes this low rate to a dramatic change on the balance sheets of commercial banks, and to a corresponding change on the balance sheet of the Federal Reserve (Fed) since 2008. What is the category on these balance sheets that Campbell believes explains very low interest rates on CDs?Explanation / Answer
On these balance sheets CDs are classified as “time deposits”. The reason why this classification explains the low interest rates on CDs is that they are lower risk investment mechanisms as the buyer of CDs is guaranteed a specified interest rate. The bank stands to gain as it has funds available for a specified amount of time.
The classification of CDs as time deposits thus explains why the interest rates on these instruments tend to be low. Another reason for the low interest rate is that CDs are not only insured by the issuing bank but also by Federal Deposit Insurance Corporation.
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