Certificate of Deposit (CD) & Commercial Paper (CP)

1. Certificate of Deposit (CD)

A. Meaning of Certificate of Deposit

A Certificate of Deposit (CD) is a negotiable, interest-bearing instrument issued by banks and other financial institutions to raise short-term funds. It represents a time deposit with a fixed maturity date and interest rate, and is issued at a discount to its face value.

B. Features of Certificate of Deposit

• Issuer: Scheduled commercial banks and financial institutions.
• Maturity: Typically ranges from 7 days to 1 year for CDs issued by banks, and from 1 year to 3 years for CDs issued by financial institutions.
• Minimum Investment: The minimum investment amount is typically ₹1 lakh and in multiples of ₹1 lakh.
• Form: Issued in either dematerialized (electronic) or physical form, providing flexibility to investors.
• Premature Withdrawal: Generally, premature withdrawal is not allowed, restricting liquidity before maturity.
• Liquidity: CDs are highly liquid as they can be traded in the secondary market, allowing investors to convert them to cash before maturity if needed.

C. Numerical Example on Certificate of Deposit

Example:

A bank issues a Certificate of Deposit with a face value of ₹1,00,000 at a discounted price of ₹97,000 for a maturity period of 6 months. Calculate the annualized yield on the CD.

Solution:

Using the Discount Yield Formula:

Yield = ((Face Value - Issue Price) / Issue Price) × (365 / Days to Maturity) × 100

Plugging in the values:

Yield = ((1,00,000 - 97,000) / 97,000) × (365 / 180) × 100

= (3,000 / 97,000) × 2.027 × 100

= 0.0309 × 2.027 × 100

= 6.26% (Annualized Yield)

Therefore, the annualized yield on the Certificate of Deposit is approximately 6.26%.

2. Commercial Paper (CP)

A. Meaning of Commercial Paper

Commercial Paper (CP) is an unsecured, short-term promissory note issued by corporations, non-banking financial companies (NBFCs), and other creditworthy entities to meet their working capital requirements. CPs are typically issued at a discount to their face value and are redeemed at face value upon maturity.

B. Features of Commercial Paper

• Issuer: Corporations, NBFCs, Primary Dealers, and other entities with high credit ratings.
• Maturity: Typically ranges from 7 days to 1 year, providing short-term funding options.
• Minimum Investment: The minimum investment amount is ₹5 lakh and in multiples of ₹5 lakh.
• Issuance: Issued at a discount to the face value, with the difference representing the investor's return.
• Credit Rating: CPs are issued only by companies with high credit ratings, ensuring a relatively low risk of default.
• Liquidity: CPs can be traded in the secondary market, offering liquidity to investors.

C. Numerical Example on Commercial Paper

Example:

A company issues a Commercial Paper with a face value of ₹10,00,000 at a discounted price of ₹9,75,000 for a maturity period of 120 days. Calculate the annualized yield on the CP.

Solution:

Using the Discount Yield Formula:

Yield = ((Face Value - Issue Price) / Issue Price) × (365 / Days to Maturity) × 100

Plugging in the values:

Yield = ((10,00,000 - 9,75,000) / 9,75,000) × (365 / 120) × 100

= (25,000 / 9,75,000) × 3.04 × 100

= 0.0256 × 3.04 × 100

= 7.79% (Annualized Yield)

Therefore, the annualized yield on the Commercial Paper is approximately 7.79%.

3. Key Differences Between CD & CP

Feature	Certificate of Deposit (CD)	Commercial Paper (CP)
Issuer	Banks & Financial Institutions	Corporations & NBFCs
Security	Secured	Unsecured
Maturity	7 days to 1 year (Banks), up to 3 years (FIs)	7 days to 1 year
Minimum Investment	₹1 lakh	₹5 lakh
Risk	Lower risk (issued by banks)	Higher risk (depends on the credit rating)

4. Importance of CDs & CPs in the Financial System

• CDs Provide Liquidity to Banks & Financial Institutions: CDs enable banks and financial institutions to raise short-term funds and manage their liquidity positions effectively.
• CPs Help Corporates Raise Short-Term Funds: CPs offer corporations and NBFCs a cost-effective alternative to bank loans for meeting their short-term working capital requirements.
• Money Market Efficiency: Both CDs and CPs contribute to the overall efficiency of the money market by providing a range of short-term investment and funding options.

Conclusion:

Certificates of Deposit (CDs) and Commercial Papers (CPs) are vital instruments in the money market, facilitating short-term borrowing and lending. They contribute to liquidity, financial stability, and economic activity.