Bank products, Eurodollars, & Eurobonds

While bank products are part of the world of finance, many are not considered securities and therefore are not tested on this exam. However, some bank issues crossover into the world of securities. We’ll only need to know the basics of these products and how they may be utilized as investments. We’ll cover these three products in this section:

• Demand deposits
• Certificates of deposit (CDs)
• Jumbo CDs

Demand deposits are funds held in bank accounts that allow withdrawals anytime. Checking and savings accounts are the most popular versions of these accounts.

Certificates of deposit (CDs) are very similar to bonds, but are only issued by banks. CDs pay a fixed rate of return based on the principal deposited, which is like a bond’s par value. The bank takes a deposit for a predetermined amount of time, pays interest, then pays the principal back at maturity. Does this sound familiar?

Jumbo CDs, also known as negotiable CDs, are large CDs that trade in the secondary market. With a minimum denomination of $100,000 and common denominations of $1 million or more, many retail investors cannot afford these investments. Financial institutions purchase these to park significant cash in a safe investment vehicle or repackage them into smaller products to sell to retail investors. Typical institutional investors that purchase jumbo CDs include pension plans, mutual funds, and large financial organizations. Because of the larger minimum investment, banks tend to offer higher rates on their jumbo CDs than traditional CDs. Jumbo CDs are typically short-term, with many maturing within one year or less from issuance. Some jumbo CDs last as short 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, banking customers would lose their money if their bank went bankrupt. FDIC insurance, which banks pay for by government mandate, covers customer deposits up to $250,000 per bank.

Investors can obtain brokered CDs from financial firms like broker-dealers that buy large quantities of individual CDs (sometimes Jumbo CDs) and re-sell them to their customers. Because the broker-dealer is buying in bulk from the bank, they can obtain higher yields for their customers than if they (the customers) went directly to the bank. Brokered CDs maintain maturities all across the spectrum, spanning from as short as a month up to 30 years. Similar to jumbo CDs, brokered CDs are negotiable and can be traded in the secondary market before maturity.

As long as the CD is eventually titled in the customer’s name (which they all are upon purchase), the investor obtains FDIC insurance of up to $250,000 per bank. One of the advantages of brokered CDs is the ability to obtain more FDIC insurance due to broker-dealers typically offering brokered CDs from several different banks. If an investor wanted $1 million of FDIC insurance, they could buy four $250,000 brokered CDs from four different banks through one brokerage firm. They’re fully insured as long as they don’t exceed $250,000 per bank. Given the lack of risk CDs expose investors to, they provide relatively low yields (compared to other debt securities). They are most suitable for investors seeking a safe shelter for cash.

Eurodollar deposits

The US Dollar is considered the world’s reserve currency, resulting in a significant number of goods and services bought and sold worldwide in dollars. For this reason, it’s not uncommon to find our currency in foreign countries. When a US Dollar is held in an account outside the United States, it is known as a Eurodollar deposit.

Don’t get confused with the name - even if the US Dollar is held in a foreign country outside of Europe, it’s still considered a Eurodollar deposit. For example, US Dollars held in Ecuador, Nigeria, or South Korea are Eurodollar deposits.

Eurobonds

A Eurobond is a debt security that pays interest and principal in a denomination other than the currency of the country it was issued in. For example, assume a Japanese company plans on building a factory in Canada. The company finds there’s Canadian demand for the Japanese Yen and decides to issue a Yen-paying bond in Canada to finance the building of the factory. Canadian investors purchasing this bond would be faced with currency (exchange rate) risk, which occurs when there’s the potential for loss related to currency conversion.

When the currency exchange rate between the Japanese Yen and Canadian Dollars fluctuates, it could result in losses for the Canadian investors mentioned above. As Canadian investors receive interest in Japanese Yen over the bond’s life (and the principal at maturity), the currency will eventually be converted back to Canadian Dollars. Currency risk would occur if the Japanese Yen weakened (same as the Canadian Dollar strengthening). The weaker Yen becomes, the fewer Canadian Dollars received when the bond’s proceeds are converted. To summarize, currency risk occurs when:

• Converting into a strong currency*
• Converting out of a weak currency*

*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 occurs when an investor must convert one currency to another. In most circumstances, this risk is not a concern for American investors purchasing securities denominated in US Dollars. However, an investor could face a “second-degree” version of this risk. For example, a company with international sales of its goods and services in many different currencies may face losses due to currency rate fluctuations. This could lead to the stock price falling, especially if the currency risk significantly impacted the company’s earnings (profits).

Eurodollar bonds

A Eurodollar bond is a specific type of Eurobond that pays US Dollars. Specifically, a Eurodollar bond is a debt security that pays interest and principal in US Dollars but is issued outside of the United States. Given that the US Dollar is in demand globally, Eurodollar bonds are relatively popular worldwide. They are issued by all types of organizations, including:

• US corporations
• US municipalities*
• Foreign corporations
• Foreign governments

American municipalities have a history of issuing Eurodollar bonds, but the federal government does not. Treasury securities are some of the most demanded securities in the world. The US Government (the issuer of Treasuries) offers them at their Treasury auction, which always occurs in the United States. Essentially, the US Government forces foreign investors to come to them. Therefore, the US Government does not technically issue Eurodollar bonds.

Eurodollar bonds are particularly enticing for an American issuer, as they face no currency risk but gain access to funding from foreign investors. A domestically-issued bond and Eurobond are relatively the same for these issuers - both pay interest and principal in US Dollars. Of course, foreign issuers face currency risk, as a conversion from their primary currency to US Dollars must occur to make required interest and principal payments. Foreign investors face the same risk when converting their bond proceeds into their home currency.