While bank products are part of the world of finance, many aren’t considered securities and therefore aren’t tested on this exam. However, some bank products overlap with securities concepts. You only need the basics of these products and how they may be used as investments. This section covers:
Demand deposits are funds held in bank accounts that allow withdrawals at any time. Checking and savings accounts are the most common examples.
Certificates of deposit (CDs) are similar to bonds, but they’re issued by banks. A CD pays a fixed rate of return based on the principal deposited, which is similar to a bond’s par value. The bank accepts a deposit for a predetermined period, pays interest during the term, and then returns the principal at maturity.
Jumbo CDs, also called negotiable CDs, are large CDs that trade in the secondary market. They have a minimum denomination of $100,000, and $1 million (or more) denominations are common, which puts them out of reach for many retail investors. Financial institutions often buy jumbo CDs to park large amounts of cash in a relatively safe vehicle, or they may repackage them into smaller products for retail investors. Typical institutional buyers include pension plans, mutual funds, and large financial organizations.
Because the minimum investment is larger, banks often offer higher rates on jumbo CDs than on traditional CDs. Jumbo CDs are typically short-term, with many maturing within one year (or less) from issuance. Some mature in as little as one week.
Bank deposits are generally covered by federally mandated insurance. FDIC insurance covers the loss of funds due to bank failure. Without this insurance, customers could lose their deposits if a bank went bankrupt. FDIC insurance (which banks are required to pay for) covers customer deposits up to $250,000 per bank.
Investors can obtain brokered CDs from financial firms such as broker-dealers. These firms buy large quantities of individual CDs (sometimes jumbo CDs) and then resell them to customers. Because the broker-dealer buys in bulk, it may be able to offer higher yields than a customer could get by going directly to the bank.
Brokered CDs are available across a wide range of maturities, from as short as one month to as long as 30 years. Like jumbo CDs, brokered CDs are negotiable and can be traded in the secondary market before maturity.
As long as the CD is titled in the customer’s name (which occurs upon purchase), the investor receives FDIC insurance of up to $250,000 per bank. One advantage of brokered CDs is that you can spread deposits across multiple banks (often through a single broker-dealer) to increase total FDIC coverage. For example, to obtain $1 million of FDIC insurance, an investor could buy four $250,000 brokered CDs from four different banks through one brokerage firm. The deposits are fully insured as long as the investor doesn’t exceed $250,000 per bank.
Because CDs generally expose investors to relatively low risk, they tend to offer relatively low yields (compared to other debt securities). They’re most suitable for investors looking for a safe place to hold cash.
The US Dollar is considered the world’s reserve currency, so many goods and services around the world are bought and sold in dollars. As a result, it’s common for US Dollars to be held in foreign countries. When a US Dollar is held in an account outside the United States, it’s called a Eurodollar deposit.
Don’t let the name mislead you: even if the US Dollar is held in a country outside Europe, it’s still considered a Eurodollar deposit. For example, US Dollars held in Ecuador, Nigeria, or South Korea are Eurodollar deposits.
A Eurobond is a debt security that pays interest and principal in a denomination other than the currency of the country where it was issued. For example, suppose a Japanese company plans to build a factory in Canada. The company finds there’s Canadian demand for Japanese Yen and decides to issue a Yen-paying bond in Canada to finance the project.
Canadian investors who buy this bond face currency (exchange rate) risk, which is the potential for loss due to currency conversion.
If the exchange rate between the Japanese Yen and Canadian Dollars changes, the Canadian investors’ returns (in Canadian Dollars) can change as well. The investors receive interest in Japanese Yen over the bond’s life (and principal at maturity), and those Yen will eventually be converted back into Canadian Dollars. Currency risk occurs if the Japanese Yen weakens (which is the same as the Canadian Dollar strengthening). The weaker the Yen becomes, the fewer Canadian Dollars the investors receive when they convert the bond proceeds.
To summarize, currency risk occurs when:
*A currency’s strength or weakness is always compared to another currency. For example, the US Dollar is considered strong compared to the Vietnamese Dong. Stating the Dong is weak compared to the US Dollar is saying the same thing.
Currency risk generally comes up when an investor must convert one currency into another. In most cases, this isn’t a concern for American investors buying securities denominated in US Dollars. However, investors can still face an indirect (“second-degree”) version of this risk. For example, a company that sells goods and services internationally (and receives revenue in multiple currencies) may see earnings decline if exchange rates move against it. If currency movements significantly reduce profits, the company’s stock price could fall.
A Eurodollar bond is a specific type of Eurobond that pays US Dollars. More precisely, it’s a debt security that pays interest and principal in US Dollars but is issued outside of the United States. Because the US Dollar is in global demand, Eurodollar bonds are relatively popular worldwide. They’re issued by many types of organizations, including:
American municipalities have a history of issuing Eurodollar bonds, but the federal government does not. Treasury securities are among the most demanded securities in the world. The US Government (the issuer of Treasuries) offers them at Treasury auctions, which always occur in the United States. In effect, foreign investors must come to the US market to buy them. Therefore, the US Government does not technically issue Eurodollar bonds.
Eurodollar bonds can be attractive to American issuers because they gain access to foreign investors without taking on currency risk (the bond pays in US Dollars). From the issuer’s perspective, a domestically issued bond and a Eurodollar bond are similar in that both require interest and principal payments in US Dollars.
Foreign issuers, however, may face currency risk because they may need to convert from their home currency into US Dollars to make interest and principal payments. Foreign investors can face similar risk when converting US Dollar bond proceeds back into their home currency.
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